Understanding Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, or 'perps', are a cornerstone of the crypto market, offering a unique way to gain leveraged exposure to asset prices without actually owning the asset. Despite their widespread use, the inner workings of perps remain poorly understood. To grasp perps, it's essential to look at their origins. In traditional finance, futures contracts provide a means to gain exposure to an asset's price, but these contracts come with an expiry date. When the expiry date arrives, the contract settles, and traders must roll their positions into a new contract if they wish to maintain their exposure. In the early days of crypto, this approach led to persistent issues. Futures contracts traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure. Moreover, when contracts expired, positions were automatically closed, regardless of the trader's intentions. BitMEX, a derivatives exchange founded in 2014, attempted to resolve these issues by shortening contract durations, but this proved insufficient. The breakthrough came with the introduction of perpetual swaps, which eliminated the expiry date altogether. This innovation allowed traders to hold positions indefinitely, without the need for rolling or settlement. However, this created a structural challenge: without an expiry date, the contract price could drift away from the spot price of the underlying asset. To address this, a funding rate mechanism was introduced, where payments are exchanged between traders on opposite sides of the market every eight hours. If the perpetual swap price exceeds the spot price, long position holders pay short position holders, and vice versa. This mechanism creates a self-correcting equilibrium, where the funding rate adjusts to pull the contract price back toward the spot price. The funding rate is calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. Another key feature of perpetual swaps is leverage. Exchanges allow traders to control large positions with relatively small amounts of capital, although limits vary by platform and jurisdiction. To manage the risks associated with leverage, exchanges employ automated liquidation systems, which close positions when losses approach the value of the deposited margin. The speed and reliability of these liquidation engines have become a key differentiator in the market. Perpetual swaps have become the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. The structure of perpetual swaps has proven durable, and regulators are now exploring their application to traditional assets, potentially leading to the listing of perpetual swaps on equities.