Understanding Perps: The Hottest Trading Instrument in Crypto

Perpetual swaps, or 'perps', have become the go-to trading instrument for crypto enthusiasts, with an estimated $40 trillion to $50 trillion traded annually. They offer a unique way to gain leveraged exposure to assets like bitcoin without actually owning them. However, their inner workings are not well understood. To grasp perps, it's essential to look at their origins. In traditional finance, futures contracts provide leveraged exposure to assets, but they expire on a specific date. When this happens, traders must roll their positions into the next contract. In crypto's early days, this created issues, such as futures trading at a premium to the spot price, known as basis, which confused traders. The expiry of contracts also led to unwanted position closures. BitMEX, a derivatives exchange, attempted to solve this by shortening contract durations, but it wasn't enough. The solution came in the form of perpetual swaps, which eliminate the expiry date altogether. This allows traders to hold positions indefinitely, without the need for rolling or settlement. However, this created a new challenge: without an expiry date, the contract price could drift away from the spot price. To address this, a mechanism was developed where traders on opposite sides of the market exchange payments every eight hours. If the perpetual swap price is above the spot price, long traders pay short traders, and vice versa. This funding rate mechanism has become the industry standard. Perpetual swaps also offer leverage, allowing traders to control large positions with minimal capital. However, this comes with significant risk, and exchanges use automated liquidation systems to manage this risk. Perpetual swaps have become the primary venue for price discovery in crypto, with regulators now exploring their application to traditional assets.