Uncovering Perps: The Ultimate Guide to Crypto's Most Popular Trading Instrument

Perpetual swaps, commonly referred to as 'perps,' have become the dominant force in the crypto trading landscape, facilitating an estimated $40 trillion to $50 trillion in annual volume. They surpass spot trading in popularity and are the go-to instrument for professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin and other assets without actually owning them. Despite their widespread use, the underlying mechanics of perps remain poorly understood. To grasp the concept of perps, it's essential to examine their predecessors. In traditional finance, leveraged exposure to an asset is typically achieved through futures contracts, which involve an agreement to buy or sell an asset at a predetermined price on a specific date. When the contract expires, it must be rolled over into a new contract to maintain the position. In the early days of crypto, this practice created persistent issues. Futures contracts often traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure to the asset's price movements. Furthermore, when a contract expired, positions were automatically closed, regardless of the trader's intentions. BitMEX, a derivatives exchange founded by Arthur Hayes and Ben Delo in 2014, attempted to address these issues by shortening contract durations, but this approach ultimately proved insufficient. The introduction of perpetual swaps in 2016 revolutionized the landscape by eliminating expiry dates altogether. This innovative contract allows traders to hold positions indefinitely, without the need for rolling or settlement. However, this created a new challenge: without an expiry date to anchor the contract price, it could deviate significantly from the underlying asset's spot price. To mitigate this, BitMEX implemented a funding rate mechanism, which has since become an industry standard. Every eight hours, traders on opposite sides of the market exchange payments, with the rate determined by the contract's deviation from the spot price over the preceding eight-hour period. This self-correcting mechanism helps maintain equilibrium, as high funding rates discourage traders from holding positions that deviate significantly from the spot price. The funding rate is now widely used across major derivatives exchanges. Another key aspect of perpetual swaps is leverage. Exchanges often allow traders to control large positions with relatively small amounts of capital, although limits vary by platform and jurisdiction. To manage the associated risks, perpetual swap platforms employ automated liquidation systems, which close positions before they can incur significant losses. The speed and reliability of these systems have become a key differentiator in the market. Perpetual swaps have become the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. The structure developed by Delo in 2016 has proven durable, and regulators are now exploring its application to traditional assets, with the potential for perpetual swaps on equities to be listed on the CME.