Understanding Perpetual Swaps: The Dominant Force in Crypto Trading

Perpetual swaps, or 'perps,' have become the go-to instrument for crypto traders seeking leveraged exposure to assets like bitcoin without actually owning them. Despite their widespread use, the inner workings of perps remain poorly understood. To grasp perps, it's essential to consider their origins. In traditional finance, futures contracts provide leveraged exposure to assets, but these contracts expire on a specific date, requiring traders to roll over their positions to maintain exposure. In crypto's early days, this led to persistent issues, including futures trading at a premium to spot prices, known as basis, which caused confusion among retail traders. The expiration of contracts also resulted in unwanted position closures. BitMEX, a derivatives exchange founded in 2014, attempted to resolve these issues by shortening contract durations, but this proved insufficient. The perpetual swap, developed by Ben Delo and launched by BitMEX in 2016, addressed these problems by eliminating expiration dates. This created a derivative contract that tracks an asset's price indefinitely, with no settlement date, rolling, or expiration. Traders can now hold positions for any duration. To maintain price equilibrium, a mechanism was introduced where payments are exchanged between traders on opposite sides of the market every eight hours. If the perpetual swap price exceeds the spot price, long-position traders pay short-position traders, and vice versa if the swap price is below spot. This funding rate is calculated based on the deviation between the swap and spot prices over the preceding eight hours. The further the deviation, the higher the funding rate, creating a self-correcting equilibrium. When long positions become expensive due to high funding rates, demand decreases, and the price moves toward the spot price. Market makers accelerate this process by shorting the perpetual swap and buying spot when a premium emerges, capturing the difference as profit. The funding rate mechanism has become an industry standard, adopted by major derivatives exchanges worldwide. Perpetual swaps also feature leverage, allowing traders to control large positions with relatively small amounts of capital. To mitigate the risks associated with leverage, exchanges use automated liquidation systems to close positions before they incur losses. The efficiency of these systems has become a key competitive factor among exchanges. Today, perpetual swaps are the primary venue for crypto price discovery, with significant price movements often originating in perp markets before spreading to spot markets. The structure of perpetual swaps has proven durable, and regulators are now exploring their application to traditional assets, potentially leading to the listing of perpetual swaps on equities by the CME.