Understanding Perpetual Swaps: The Hottest Crypto Trading Instrument Explained

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 assets like bitcoin without actually owning them. Despite their popularity, the inner workings of perps are not well understood. To grasp the concept of perps, it's essential to look at their origins. In traditional finance, traders typically use futures contracts to gain exposure to an asset. However, these contracts expire on a specific date, and traders must roll them over to maintain their position. In the early days of crypto, this created issues, such as futures trading at a premium to the spot price, known as basis, which confused retail traders. The expiration of contracts also led to the closure of positions, regardless of the traders' intentions. BitMEX, a derivatives exchange, addressed these problems by introducing perpetual swaps in 2016. These contracts have no expiration date, allowing traders to hold positions for any duration. The exchange solved the issue of contract prices deviating from spot prices by introducing a funding rate mechanism. Every eight hours, traders on opposite sides of the market exchange payments, which helps to maintain a self-correcting equilibrium. The funding rate is calculated based on the deviation of the perpetual swap price from the spot price over the preceding eight-hour window. This mechanism has become an industry standard, used by major derivatives exchanges worldwide. Perpetual swaps also offer leverage, allowing traders to control larger positions with smaller amounts of capital. However, this increases the risk, and exchanges use automated liquidation systems to manage it. The reliability and speed of these systems have become a key differentiator in the market. Today, perpetual swaps are the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. The concept has proven so durable that regulators are now exploring its application to traditional assets, with the potential for perpetual swaps on equities to be listed on the CME.