Understanding Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, or 'perps', are a type of trading instrument that has taken the crypto market by storm, allowing traders to gain leveraged exposure to assets like bitcoin without actually owning them. Despite their widespread use, the inner workings of perps remain somewhat mysterious. To grasp the concept of perps, it's essential to understand the traditional financial instruments that preceded them, such as futures contracts. These contracts typically involve an agreement to buy or sell an asset at a predetermined price on a specific date, after which the contract expires and must be rolled over into a new one. However, this process created issues in the crypto market, including a persistent price disparity between futures and spot prices, known as basis. The expiry of contracts also led to unwanted position closures. In response, BitMEX developed the perpetual swap, which eliminated the expiry date and enabled traders to hold positions indefinitely. A crucial mechanism was introduced to maintain price equilibrium: every eight hours, a payment is made between traders on opposite sides of the market, based on the deviation between the perpetual swap price and the spot price. This funding rate helps to self-correct the market, making it expensive to hold positions when the price deviates significantly from spot. Leverage is another defining feature of perpetual swaps, allowing traders to control larger positions with smaller amounts of capital. However, this also increases the risk of significant losses, which exchanges manage through automated liquidation systems. Perpetual swaps have become the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. Their success has also led to interest from regulators and traditional financial institutions, with potential applications in equities and other assets.