Understanding Perpetual Swaps: The Dominant Force in Crypto Trading

Perpetual swaps, also known as perpetual futures, have become the go-to instrument for crypto traders, facilitating an estimated $40 trillion to $50 trillion in annual trading volume. They offer a unique way for traders to gain leveraged exposure to cryptocurrency prices without actually owning the underlying asset. Despite their widespread use, the inner workings of perpetual swaps remain poorly understood. To grasp the concept, it's essential to look at the traditional finance backdrop, where futures contracts provided a means to gain leveraged exposure to assets, albeit with an expiry date. However, this created issues in the crypto space, such as basis and contract expirations, which confused traders. The launch of perpetual swaps on BitMEX in 2016 addressed these problems by eliminating the expiry date, allowing traders to hold positions indefinitely. A key mechanism, known as the funding rate, ensures the contract price stays in line with the underlying asset's spot price. Every eight hours, traders on opposite sides of the market exchange payments, with the rate determined by the deviation from the spot price. This self-correcting equilibrium has become an industry standard. Another defining feature of perpetual swaps is leverage, enabling traders to control large positions with minimal capital. To mitigate risks, exchanges employ automated liquidation systems. Perpetual swaps have become the primary venue for price discovery in crypto, with regulators exploring their application to traditional assets. The structure has proven durable, transforming a workaround for crypto futures limitations into one of the most traded financial products globally.