Understanding Perpetual Swaps: The Dominant Force in Crypto Trading

Perpetual swaps, also known as perps, have revolutionized the crypto trading landscape by providing a futuristic trading instrument that processes an estimated $40 trillion to $50 trillion in volume annually. They surpass spot trading in popularity and are the go-to product for professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin and other assets without holding the underlying asset. Despite their widespread adoption, the inner workings of perpetual swaps remain poorly understood. To grasp the concept of perps, it's essential to understand the traditional finance backdrop. Typically, leveraged exposure to an asset is achieved through a futures contract, which is an agreement to buy or sell at a predetermined price on a specific date. Upon expiration, the contract settles, and traders must roll over their position to maintain it. In the early days of crypto, this practice led to persistent issues, including futures trading at a premium to the spot price of bitcoin, known as basis, which confused retail traders seeking straightforward exposure. Moreover, contract expirations resulted in positions being closed, regardless of the traders' intentions. BitMEX, founded by Arthur Hayes and Ben Delo in 2014, attempted to address these issues by shortening contract durations, but this proved insufficient. The perpetual swap, developed by Delo and launched by BitMEX in 2016, resolved these problems by eliminating the expiry date, creating a derivative contract that tracks the asset price indefinitely. This innovation allowed traders to hold positions for extended periods without the need for rolling over contracts. However, this created a structural challenge, as the lack of an expiry date meant that nothing would naturally force the contract price back to the spot price. BitMEX addressed this issue through a funding rate mechanism, which has since become the industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market, with the rate calculated based on the deviation of the perpetual swap price from the spot price over the preceding eight-hour window. This self-correcting mechanism ensures that the price remains aligned with the spot price. The funding rate mechanism has been adopted by every major derivatives exchange worldwide. Another key feature of perpetual swaps is leverage, which allows traders to control positions significantly larger than their deposited capital. To manage the associated risks, exchanges use automated liquidation systems to close positions before they can incur 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. 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 to be listed on equities.