Understanding Perpetual Swaps: The Driving Force Behind Crypto's Trading Landscape

Perpetual swaps, or 'perps', have become the cornerstone of the crypto trading landscape, facilitating leveraged exposure to assets like bitcoin without requiring ownership of the underlying asset. Despite their widespread adoption, the inner workings of perps remain shrouded in mystery. To grasp the concept of perps, it's essential to understand their predecessors. In traditional finance, futures contracts are used to gain leveraged exposure to an asset, with an agreement to buy or sell at a predetermined price on a specific date. However, this approach created persistent issues in the early days of crypto, including the 'basis' phenomenon, where futures traded at a premium to the spot price of bitcoin, causing confusion among retail traders. The expiration of contracts also led to the involuntary closure of positions, regardless of the traders' intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but to no avail. The perpetual swap, developed by Ben Delo and launched by BitMEX in 2016, revolutionized the landscape by eliminating the expiry date altogether. This created a derivative contract that tracks the price of an asset indefinitely, allowing traders to maintain positions for extended periods. To prevent the contract price from deviating significantly from the spot price, a funding rate mechanism was introduced. Every eight hours, a payment is exchanged between traders on opposite sides of the market, with the rate calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. This self-correcting equilibrium ensures that the price remains anchored to the spot price. The funding rate mechanism has since become an industry standard, adopted by major derivatives exchanges worldwide. Another defining feature of perpetual swaps is leverage, which enables traders to control positions significantly larger than their deposited capital. To mitigate the risks associated with leverage, exchanges employ automated liquidation systems, which close positions before they can incur negative balances. The reliability and speed of these systems have become a key differentiator in the market. Perpetual swaps have now become the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. The structure developed by Delo in 2016 has proven resilient, and regulators in the U.S. are exploring its application to traditional assets, with the potential listing of perpetual swaps on equities by the CME. What began as a solution to the limitations of crypto futures has evolved into one of the most traded financial products globally.