Understanding Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, also known as perps, have revolutionized the crypto market by providing a unique trading instrument that offers leveraged exposure to asset prices without owning the underlying asset. With estimated annual trading volumes of $40 trillion to $50 trillion, perps have surpassed spot trading and become the go-to product for professional traders, hedge funds, and retail speculators. Despite their widespread adoption, the inner workings of perps remain poorly understood. To grasp the concept of perps, it is essential to understand the traditional finance context. In conventional finance, leveraged exposure to an asset typically involves a futures contract, which is an agreement to buy or sell an asset at a predetermined price on a specific date. When the contract expires, it must be rolled over into a new contract to maintain the position. However, this approach created persistent problems in the early days of crypto. Futures contracts traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure to price movements. Furthermore, when contracts expired, positions were automatically closed, regardless of the trader's intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but this proved insufficient. The breakthrough came with the introduction of perpetual swaps, which eliminated the expiry date and created a derivative contract that tracks the asset price indefinitely. This innovation allowed traders to hold positions for extended periods without the need for rolling or expiry. The perpetual swap mechanism, developed by Ben Delo and launched on BitMEX in 2016, resolved the issue of expiry dates and created a self-correcting equilibrium. Every eight hours, a payment is exchanged between traders on opposite sides of the market, based on the deviation of the perpetual swap price from the spot price. This funding rate mechanism has become the industry standard and is used by major derivatives exchanges worldwide. Perpetual swaps also offer leverage, allowing traders to control positions significantly larger than their deposited capital. To manage the associated risks, exchanges use automated liquidation systems to close positions before they can incur negative balances. The speed and reliability of these systems have become a key competitive 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 structure of perpetual swaps has proven durable enough that regulators are now exploring its application to traditional assets, with the potential for listing perpetual swaps on equities.