Understanding Perps: The Hottest Trading Instrument in Crypto

Perpetual swaps, also known as perps, are a type of derivative contract that has revolutionized the crypto market. They allow traders to gain leveraged exposure to the price of assets like bitcoin without actually owning them. Despite their widespread use, the mechanics behind perps are not well understood. To grasp how perps work, it's essential to understand the traditional finance context. In the past, traders used futures contracts to gain leveraged exposure to assets, but these contracts had expiration dates, which led to issues like basis and forced position closures. BitMEX, a derivatives exchange, addressed these problems by introducing perpetual swaps in 2016. These contracts have no expiration date and allow traders to hold positions indefinitely. A key mechanism that keeps perps in check is the funding rate, which is a payment exchanged between traders every eight hours. This rate helps to maintain a self-correcting equilibrium by incentivizing traders to adjust their positions. Perps also offer high leverage, which can be both a blessing and a curse. To mitigate the risks associated with high leverage, exchanges use automated liquidation systems to close positions before they become too risky. Today, perps are the primary venue for price discovery in crypto, with their influence extending to traditional assets. Regulators are now exploring the application of perps to equities, a testament to the durability and versatility of this financial instrument.