Understanding Perpetual Swaps: The Hottest Trading Instrument in Crypto

Perpetual swaps, also known as perps, are a type of trading instrument that has gained immense popularity in the crypto market. They are a type of derivative contract that allows traders to have leveraged exposure to the price of an asset, such as bitcoin, without actually owning the underlying asset. To comprehend perps, it's essential to understand their origins. In traditional finance, traders typically gain leveraged exposure to an asset through a futures contract, which is an agreement to buy or sell an asset at a predetermined price on a specific date. However, in the crypto market, this approach created persistent issues. Futures contracts traded at a premium to the spot price of bitcoin, causing confusion among retail traders. Moreover, when a contract expired, positions were closed, regardless of the trader's intentions. BitMEX, a derivatives exchange, addressed this issue by introducing perpetual swaps in 2016. A perpetual swap is a derivative contract that tracks the price of an asset indefinitely, without an expiry date. This innovation eliminated the need for rolling contracts and resolved the issue of basis. The perpetual swap mechanism involves a funding rate, which is exchanged between traders on opposite sides of the market every eight hours. This rate is calculated based on the deviation of the perpetual swap price from the spot price. The funding rate creates a self-correcting equilibrium, where the price of the perpetual swap is pulled back towards the spot price. Market makers accelerate this process by shorting the perpetual swap and buying spot, capturing the difference as profit. Another key feature of perpetual swaps is leverage. Exchanges allow traders to control positions that are significantly larger than their deposited capital, with limits varying by platform and jurisdiction. To manage the risk associated with leverage, perpetual swap platforms use automated liquidation systems. These systems close positions before they can go negative, protecting the exchange from absorbing the deficit. Perpetual swaps have become the primary venue for price discovery in crypto, with regulators exploring their application to traditional assets. The structure of perpetual swaps has proven durable, and they are now one of the most traded financial products in the world.