Understanding Perpetual Swaps: The Dominant Force in Crypto Trading

Perpetual swaps, also known as perpetual futures or 'perps', are a type of trading instrument that has become the backbone of the crypto market. They enable traders to gain leveraged exposure to the price of assets like bitcoin without actually owning them. Despite their widespread use, the mechanics behind perps are not well understood. To grasp the concept of perps, it's essential to understand their origins. In traditional finance, traders typically use futures contracts to gain leveraged exposure to an asset. However, this approach created problems in the crypto market, where futures traded at a premium to the spot price, causing confusion among retail traders. The introduction of perpetual swaps by BitMEX in 2016 revolutionized the market by eliminating the expiry date, allowing traders to hold positions for any duration. A key mechanism in perps is the funding rate, which ensures that the contract price remains aligned with the spot price. Every eight hours, traders on opposite sides of the market exchange payments, with the rate calculated based on the deviation from the spot price. This self-correcting equilibrium is maintained by market makers who short the perpetual swap and buy spot when a premium opens up. Leverage is another defining feature of perps, allowing traders to control large positions with minimal capital. However, this also increases the risk, which is managed through 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 of perps has proven durable, and they have become one of the most traded financial products in the world.