Understanding Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, also known as perps, are a type of financial derivative that allows traders to gain exposure to the price of an asset, such as bitcoin, without actually owning it. They have become the go-to instrument for professional traders, hedge funds, and retail speculators seeking leveraged exposure to crypto prices. Despite their widespread use, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to look at their origins. In traditional finance, traders typically use futures contracts to gain leveraged exposure to an asset. However, this approach created persistent issues in the early days of crypto trading. Futures contracts often traded at a premium to the spot price of bitcoin, causing confusion among retail traders. Furthermore, when contracts expired, traders were forced to close their positions, regardless of their intentions. The derivatives exchange BitMEX, founded in 2014, attempted to address these issues by shortening contract durations, but this didn't provide a lasting solution. The breakthrough came with the introduction of perpetual swaps, which eliminated the expiry date altogether. This innovation allowed traders to hold positions for any length of time, from hours to years. However, this created a new challenge: without an expiry date, the contract price could drift away from the underlying asset's spot price. To mitigate this, a funding rate mechanism was introduced, where traders on opposite sides of the market exchange payments every eight hours. The rate is calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. This self-correcting mechanism helps maintain equilibrium and keeps the contract price in line with the spot price. Another key feature of perpetual swaps is leverage. Traders can control large positions with relatively small amounts of capital, but this also increases the risk of significant losses. To manage this risk, exchanges use automated liquidation systems to close positions before they become unprofitable. The reliability and speed of these systems have become a key differentiator in the market. Today, perpetual swaps are the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. The concept has proven so durable that regulators are now exploring its application to traditional assets, with the potential for perpetual swaps on equities.