Understanding Perpetual Swaps: The Dominant Force in Crypto Trading

Perpetual swaps, or 'perps', have emerged as the go-to instrument for crypto traders, hedge funds, and speculators seeking leveraged exposure to assets like bitcoin. Despite their widespread adoption, the inner workings of perps remain somewhat enigmatic. To grasp the concept of perps, it's essential to understand their origins. In traditional finance, futures contracts provide a means of gaining exposure to an asset's price, but these contracts come with an expiration date, after which they must be rolled over into a new contract. The early days of crypto saw similar issues with futures contracts, which traded at a premium to the spot price, causing confusion among retail traders. The introduction of perpetual swaps by BitMEX in 2016 revolutionized the landscape by eliminating the expiration date, allowing traders to hold positions indefinitely. This innovation, however, presented a new challenge: without an expiration date, the contract price could drift away from the underlying asset's spot price. To address this, a funding rate mechanism was introduced, where traders on opposite sides of the market exchange payments every eight hours, based on the contract's deviation from the spot price. This self-correcting mechanism has become the industry standard. Perpetual swaps also offer leverage, enabling traders to control larger positions with limited capital. To mitigate the risks associated with leverage, exchanges employ automated liquidation systems to close positions before they incur significant losses. Today, perpetual swaps are the primary driver of price discovery in crypto, with regulators exploring their application to traditional assets. The perpetual swap's structure has proven resilient, and its influence extends beyond the crypto sphere, with the potential to be listed on equities by the CME.