Understanding Perpetual Swaps: The Dominant Trading Instrument in Crypto

Perpetual swaps, also known as perps, are a type of derivative contract that has become the primary trading instrument in the crypto market, with an estimated annual volume of $40 trillion to $50 trillion. They allow traders to gain leveraged exposure to the price of assets like bitcoin without actually owning the asset. Despite their popularity, the mechanics of perpetual swaps are not well understood. To comprehend perps, it's essential to understand the traditional financial instruments that came before them, such as futures contracts, which have an expiry date and settle at a predetermined price. However, in the crypto market, this approach created persistent problems, including basis, which is the difference between the futures price and the spot price of an asset. BitMEX, a derivatives exchange, introduced perpetual swaps in 2016 to address these issues. A perpetual swap is a contract that tracks the price of an asset indefinitely, with no expiry date or settlement. Traders can hold positions for hours or years, and the contract price is kept in check through a funding rate mechanism, which exchanges payments between traders on opposite sides of the market every eight hours. This mechanism creates a self-correcting equilibrium, where the contract price is pulled back toward the spot price of the underlying asset. Perpetual swaps also offer leverage, allowing traders to control positions larger than their deposited capital, with limits varying by platform and jurisdiction. To manage the risks associated with leverage, exchanges use automated liquidation systems to close positions before they can go negative. Perpetual swaps have become the primary venue for price discovery in crypto, with regulators exploring their application to traditional assets. The structure of perpetual swaps has proven durable, and they have become one of the most traded financial products in the world.