Uncovering Perps: The Crypto Trading Instrument That's Taking the World by Storm

Perpetual swaps, or 'perps', have become the go-to trading instrument in the crypto market, handling an estimated $40 trillion to $50 trillion in annual volume. They outshine spot trading and offer professional traders, hedge funds, and retail speculators a means to gain leveraged exposure to bitcoin and other assets without directly owning them. Despite their widespread use, the underlying mechanics of perps remain poorly understood. To grasp perps, it's essential to consider their predecessors. In traditional finance, leveraged exposure to an asset typically comes through a futures contract, which involves an agreement to buy or sell at a set price on a specific date. When this date arrives, the contract expires and settles, requiring traders to roll their positions into the next contract if they wish to maintain them. In the early days of crypto, this practice led to persistent issues. Futures traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure. Moreover, every time a contract expired, positions would close regardless of the trader's intentions. BitMEX, founded by Arthur Hayes and Ben Delo in 2014, attempted to address this by shortening contract durations, but none of these efforts proved sufficient. The perpetual swap, developed by Delo and launched by BitMEX in 2016, resolved the issue by eliminating the expiry date altogether. This created a derivative contract that tracks the price of an asset indefinitely, with no settlement date, rolling, or expiry. Traders can hold positions for hours or years, creating a structural challenge: without an expiry date, nothing would naturally force the contract price back toward the spot price. BitMEX solved this through a mechanism that has become the industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market. If the perpetual swap is trading above the spot price, indicating excess demand for long positions, traders who are long pay traders who are short. If the perpetual swap is trading below spot, the payment runs the other way, with the exchange taking no cut. The rate of this payment, known as the funding rate, is calculated based on the deviation of the perpetual swap price from spot over the preceding eight-hour window. The further the deviation, the higher the rate. This creates a self-correcting equilibrium, where high funding rates make it expensive to hold long positions, reducing demand and pulling the price back toward spot. Market makers accelerate this process by shorting the perpetual swap and buying spot whenever a meaningful premium opens up, capturing the difference as profit. The funding rate mechanism is now used by every major derivatives exchange. Perpetual swaps also offer leverage, allowing traders to control positions significantly larger than their deposited capital. To manage the risk, perpetual swap platforms use automated liquidation systems. If a trader's losses approach the value of their deposited margin, the system closes the position before it can go negative, protecting the exchange. Perpetual swaps have become the primary venue for price discovery in crypto, with bitcoin moves typically originating in perp markets before spreading to spot. The structure Delo built in 2016 has proven durable, and regulators in the U.S. are now exploring its application to traditional assets.