Uncovering Perps: The Ultimate Guide to Crypto's Most Popular Trading Instrument

Perpetual swaps, also known as 'perps', have emerged as the dominant force in the crypto market, with estimated annual trading volumes ranging from $40 trillion to $50 trillion. These financial instruments have surpassed spot trading in popularity, offering professional traders, hedge funds, and retail speculators a means of gaining leveraged exposure to bitcoin and other assets without actually owning them. Despite their widespread use, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to examine their predecessors. In traditional finance, investors typically gain leveraged exposure to an asset through futures contracts, which involve an agreement to buy or sell at a predetermined price on a specific date. When the contract expires, it settles, and traders must roll over their positions to maintain them. However, this approach created persistent issues in the early days of crypto. Futures contracts often traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure. Additionally, contract expirations resulted in the automatic closure of positions, regardless of the traders' intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but this proved insufficient. The perpetual swap, developed by Ben Delo and launched on BitMEX in 2016, resolved these problems 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 now hold positions for any duration, from hours to years. The absence of an expiry date presented a structural challenge, as nothing would naturally force the contract price back toward the spot price of the underlying asset. BitMEX addressed this issue through a mechanism that has since become the industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market. If the perpetual swap price exceeds the spot price, indicating excess demand for long positions, long traders pay short traders. Conversely, if the perpetual swap price is below the spot price, the payment flows in the opposite direction. The exchange does not take a cut of this payment, known as the funding rate, which is calculated based on the deviation of the perpetual swap price from the spot price over the preceding eight-hour window. The further the deviation, the higher the funding rate. This creates a self-correcting equilibrium, where high funding rates make it expensive for traders to hold positions, reducing demand and pulling the price back toward the spot price. Market makers accelerate this process by shorting the perpetual swap and buying spot when a significant premium emerges, capturing the difference as profit. The funding rate mechanism is now widely used by major derivatives exchanges. Another key feature of perpetual swaps is leverage. Most exchanges allow traders to control positions significantly larger than their deposited capital, with limits varying by platform and jurisdiction. At its peak, BitMEX offered leverage of up to 100 times, meaning a 1% move in bitcoin's price could result in a 100% gain or loss on a fully leveraged position. To mitigate the risks associated with high leverage, perpetual swap platforms employ automated liquidation systems. If a trader's losses approach the value of their deposited margin, the system closes the position before it can become negative, protecting the exchange from absorbing the deficit. The speed and reliability of this liquidation engine have become a key competitive differentiator in the market. Perpetual swaps have become the primary venue for price discovery in crypto, with significant price movements often originating in perp markets before spreading to spot markets. The structure developed by Delo in 2016 has proven durable, and regulators in the US are now exploring its application to traditional assets, with the CME potentially listing perpetual swaps on equities. What began as a workaround for the limitations of crypto futures has evolved into one of the most widely traded financial products globally.