Uncovering Perpetual Swaps: The Crypto Market's Most Popular Trading Instrument

Perpetual swaps, also known as 'perps', have emerged as the dominant force in the crypto trading landscape, facilitating an estimated $40 trillion to $50 trillion in annual volume. They surpass spot trading in popularity and are the go-to instrument for professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin and other assets without directly owning them. However, the inner workings of perps remain poorly understood by many. To grasp the concept of perps, it's essential to examine their predecessors. In traditional finance, futures contracts are commonly used to gain leveraged exposure to an asset, involving an agreement to buy or sell at a predetermined price on a specific date. Upon expiration, the contract settles, and traders must roll over their position to maintain it. In the early days of crypto, this approach created persistent issues. Futures contracts often traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure. Moreover, contract expirations would automatically close positions, regardless of the trader's intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but this ultimately proved insufficient. The perpetual swap, developed by Ben Delo and launched on BitMEX in 2016, revolutionized the market by eliminating the expiry date altogether. This innovative contract tracks the price of an asset indefinitely, with no settlement date, rolling, or expiry. Traders can now hold positions for any duration, from hours to years. The absence of an expiry date, however, created a new challenge: without a natural anchor, the contract price could deviate significantly from the spot price. To mitigate this, BitMEX introduced a mechanism that has since become the industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market, based on the funding rate. If the perpetual swap price exceeds the spot price, long-position traders pay short-position traders, and vice versa. The exchange does not take a cut, and the funding rate is calculated based on the deviation from the spot price over the preceding eight-hour period. This self-correcting mechanism ensures that the contract price remains aligned with the spot price. The funding rate also incentivizes market makers to short the perpetual swap and buy spot when a premium opens up, capturing the difference as profit. Leverage is another defining feature of perpetual swaps, allowing traders to control positions significantly larger than their deposited capital. To manage the associated risk, exchanges employ automated liquidation systems, which close positions before they can become negative, protecting the exchange from potential deficits. Perpetual swaps have become the primary venue for price discovery in the crypto market, with sharp moves in bitcoin often originating in perp markets before spreading to spot. The structure developed by Delo in 2016 has proven durable, and regulators are now exploring its application to traditional assets, with the CME potentially listing perpetual swaps on equities. What began as a workaround for the limitations of crypto futures has evolved into one of the most widely traded financial products globally.