Understanding Perps: The Hottest Trading Instrument in Crypto

Perpetual swaps, or 'perps,' are a type of trading instrument that has become the cornerstone of the crypto market. They enable traders to gain leveraged exposure to the price of assets like bitcoin without actually owning the underlying asset. Despite their widespread use, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to look at their predecessors. In traditional finance, traders typically use futures contracts to gain leveraged exposure to an asset. However, this approach created persistent issues in the crypto space. Futures contracts often traded at a premium to the spot price, causing confusion among traders. Moreover, when these contracts expired, traders' positions would automatically close, regardless of their intentions. The derivatives exchange BitMEX addressed these issues by introducing perpetual swaps in 2016. This innovative contract type eliminated the expiry date, allowing traders to hold positions for any duration. The exchange resolved the resulting structural challenge by implementing a funding rate mechanism. Every eight hours, traders on opposite sides of the market exchange payments, with the rate calculated based on the deviation between the perpetual swap price and the spot price. This mechanism creates a self-correcting equilibrium, where the funding rate adjusts to pull the price back toward the spot price. Perpetual swaps also offer high leverage, allowing traders to control large positions with relatively small amounts of capital. However, this leverage comes with significant risks, which exchanges manage using automated liquidation systems. Today, perpetual swaps are the primary venue for price discovery in the crypto market, with regulators exploring their application to traditional assets. The structure of perpetual swaps has proven durable, and they have become one of the most widely traded financial products globally.