Understanding Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, also known as perpetual futures, are a type of trading instrument that has revolutionized the crypto market. With estimated annual trading volumes of $40-50 trillion, they have become the go-to instrument for professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin and other assets without actually owning them. To comprehend perps, it's essential to understand their origins. In traditional finance, futures contracts provide leveraged exposure to assets, but they come with an expiry date, after which the contract settles. However, this created issues in crypto's early days, such as basis, which caused confusion among retail traders. The expiration of contracts also led to the closure of positions, regardless of the traders' intentions. BitMEX, a derivatives exchange, attempted to address these issues by shortening contract durations, but it wasn't enough. The breakthrough came with the introduction of perpetual swaps, which eliminated the expiry date altogether. This innovative contract tracks the price of an asset indefinitely, allowing traders to hold positions for hours or years. The perpetual swap mechanism involves a payment exchange between traders on opposite sides of the market every eight hours. If the swap price exceeds the spot price, long-position traders pay short-position traders, and vice versa. This funding rate mechanism creates a self-correcting equilibrium, where the price of the perpetual swap is pulled back towards the spot price. Market makers accelerate this process by shorting the perpetual swap and buying spot when a premium opens up, capturing the difference as profit. Leverage is another defining feature of perpetual swaps, allowing traders to control larger positions with deposited capital. However, this creates risk for exchanges, which is managed through automated liquidation systems. These systems close positions before they can go negative, protecting the exchange from absorbing deficits. Perpetual swaps have become the primary venue for price discovery in crypto, with regulators exploring their application to traditional assets. The structure of perpetual swaps has proven durable, and their impact on the financial world continues to grow.