Uncovering Perps: The Cryptocurrency Trading Instrument Taking the World by Storm

Perpetual swaps, commonly referred to as 'perps', have become the go-to trading instrument in the crypto market, handling an estimated $40 trillion to $50 trillion in annual volume. They overshadow spot trading and serve as the preferred choice for professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin and other assets without holding the underlying. Despite their widespread use, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to examine their predecessors. In traditional finance, leveraged exposure to assets typically involves futures contracts, which are agreements to buy or sell at a predetermined price on a specific date. Upon expiration, the contract settles, and traders must roll over their positions to maintain them. In the early days of crypto, this practice led to persistent issues. Futures traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure. Furthermore, contract expirations resulted in position closures, regardless of the traders' intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address this by shortening contract durations, but none of these efforts proved sufficient. The perpetual swap, developed by Ben Delo and launched by BitMEX in 2016, resolved the issue by eliminating the expiry date, creating a derivative contract that tracks the asset price indefinitely. This innovation introduced a structural challenge: without an expiry date, the contract price wouldn't naturally revert to the spot price. BitMEX overcame this by implementing a mechanism that has since become the industry standard. Every eight hours, traders on opposite sides of the market exchange payments. If the perpetual swap price exceeds the spot price, long-position traders pay short-position traders, and vice versa. The exchange doesn't take a cut. The funding rate, which determines the payment amount, 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 ensures that when long positions become expensive due to high funding rates, demand decreases, and the price adjusts toward the spot price. Market makers accelerate this process by shorting the perpetual swap and buying spot when a premium emerges, capturing the difference as profit. The funding rate mechanism is now widely adopted by major derivatives exchanges. Perpetual swaps are also characterized by their use of leverage. Most exchanges allow traders to control positions that exceed their deposited capital, with varying limits depending on the platform and jurisdiction. To mitigate the risks associated with leverage, perpetual swap platforms employ automated liquidation systems. If a trader's losses approach the value of their deposited margin, the system closes the position to prevent deficits. The speed and reliability of this liquidation engine have become key competitive differentiators in the market. Today, perpetual swaps have become the primary venue for price discovery in crypto, with sharp bitcoin movements often originating in perp markets before spreading to spot. The structure developed by Delo in 2016 has proven durable, and regulators in the U.S. are now exploring its application to traditional assets, with the CME potentially listing perpetual swaps on equities. What began as a solution to the limitations of crypto futures has evolved into one of the most traded financial products globally.