Understanding Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, or 'perps,' are a type of trading instrument that has revolutionized the crypto market. They allow traders to have leveraged exposure to the price of assets like bitcoin without actually owning them. Despite their widespread use, the mechanics behind perps are not well understood. To grasp perps, it's essential to understand their origins. In traditional finance, traders typically use futures contracts to gain leveraged exposure to an asset. However, these contracts have an expiration date, after which they settle, and traders must roll their positions into new contracts. In the early days of crypto, this created problems, 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 whether traders wanted to maintain them. BitMEX, a derivatives exchange, attempted to address these issues by shortening contract durations, but this didn't solve the problem. The solution came in the form of perpetual swaps, which eliminated the expiration date altogether. This allowed traders to hold positions indefinitely, without the need for rolling or settlement. However, this created a new challenge: without an expiration date, the contract price could deviate from the spot price of the underlying asset. To address this, a funding rate mechanism was introduced, where payments are exchanged between traders on opposite sides of the market every eight hours. This mechanism has become the industry standard and is used by all major derivatives exchanges. 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 creates a self-correcting equilibrium, where the price of the perpetual swap is pulled back towards the spot price. Another key feature of perpetual swaps is leverage. Exchanges allow traders to control large positions with relatively small amounts of capital, which can amplify gains but also increases the risk of significant losses. To manage this risk, exchanges use automated liquidation systems, which close positions before they can become negative. Perpetual swaps have become the primary venue for price discovery in crypto, with moves in the perp markets often preceding moves in the spot markets. Their success has also led to regulators exploring their application to traditional assets, with the potential for perpetual swaps on equities to be listed on the CME.