Understanding Perpetual Swaps: The Driving Force Behind Crypto's Trading Landscape

Perpetual swaps, or 'perps,' have become the go-to instrument for traders seeking leveraged exposure to cryptocurrency prices without actually owning the assets. Despite their widespread use, the underlying mechanics of perps remain somewhat mysterious. To grasp the concept of perps, it's essential to understand their origins. In traditional finance, investors typically gain leveraged exposure to an asset through futures contracts, which are agreements to buy or sell at a predetermined price on a specific date. However, this approach created persistent issues in the crypto space, such as futures trading at a premium to the spot price of bitcoin, known as basis, and the inconvenience of contract expirations. BitMEX, a derivatives exchange founded in 2014, addressed these problems by introducing perpetual swaps in 2016, which eliminated the expiry date and enabled traders to hold positions indefinitely. A crucial mechanism was implemented to keep the contract price aligned with the spot price: every eight hours, a payment is exchanged between traders on opposite sides of the market, based on the funding rate, which is calculated according to the deviation from the spot price. This self-correcting equilibrium has become an industry standard, adopted by major derivatives exchanges worldwide. Another key feature of perpetual swaps is leverage, allowing traders to control larger positions with lower capital, although this also increases the risk, which is managed through automated liquidation systems. Today, perpetual swaps have become the primary venue for price discovery in crypto, often driving price movements that then spread to spot markets. Their structure has proven durable, and regulators are now exploring their application to traditional assets, potentially leading to the listing of perpetual swaps on equities.