Understanding Perpetual Swaps: The Dominant Trading Instrument in Crypto

Perpetual swaps, also known as 'perps', have become the go-to trading instrument in the crypto market, with an estimated annual volume of $40 trillion to $50 trillion. These swaps allow traders to gain leveraged exposure to the price of bitcoin or other cryptocurrencies without actually owning the underlying asset. However, the mechanics behind them are not well understood. To grasp the concept of perps, it's essential to understand the traditional finance context. Typically, traders use futures contracts to gain leveraged exposure to an asset, which involves agreeing to buy or sell at a set price on a specific date. When the contract expires, traders must roll over their position to maintain it. In the early days of crypto, this process created persistent issues, such as futures trading at a premium to the spot price, known as basis, and positions closing automatically when contracts expired. BitMEX, a derivatives exchange, addressed these problems by introducing perpetual swaps in 2016. These swaps eliminated the expiry date, allowing traders to hold positions indefinitely. To maintain the contract price in line with the spot price, BitMEX implemented a funding rate mechanism, where traders on opposite sides of the market exchange payments every eight hours. This mechanism has become the industry standard. Perpetual swaps also offer leverage, enabling traders to control larger positions with minimal capital. However, this increases the risk, and exchanges use automated liquidation systems to manage it. Today, perpetual swaps are 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 globally.