Understanding Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, or 'perps', have revolutionized the crypto market by providing a unique trading instrument that offers leveraged exposure to asset prices without owning the underlying asset. With estimated annual trading volumes of $40 trillion to $50 trillion, perps have surpassed spot trading and have become the go-to product for professional traders, hedge funds, and retail speculators. Despite their widespread adoption, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to understand the traditional finance context. In the past, traders relied on futures contracts to gain leveraged exposure to assets, which came with an expiry date and required contract rollovers. However, this approach created persistent issues in the crypto market, including basis and contract expiries that confused traders. The introduction of perps by BitMEX in 2016 addressed these problems by eliminating the expiry date, creating a derivative contract that tracks asset prices indefinitely. The perpetual swap mechanism involves a funding rate that is exchanged between traders every eight hours, which helps to maintain a self-correcting equilibrium and keeps the contract price in line with the spot price of the underlying asset. Leverage is another key feature of perps, allowing traders to control large positions with limited capital, although this also increases the risk of significant losses. To mitigate this risk, exchanges use automated liquidation systems to close positions before they become negative. Perps have become the primary venue for price discovery in crypto, with regulators now exploring their application to traditional assets. The structure of perps has proven durable, and their impact on the financial markets is likely to continue to grow.