Uncovering Perps: The Ultimate Guide to Crypto's Most Popular Trading Instrument

Perpetual swaps, or 'perps', have become the go-to instrument for crypto traders, processing an estimated $40 trillion to $50 trillion in annual volume. They offer a unique form of leveraged exposure to assets like bitcoin, without the need for ownership. Despite their widespread use, the underlying mechanics of perps remain poorly understood. To grasp the concept of perps, it's essential to consider their predecessors. Traditional finance typically provides leveraged exposure through futures contracts, which expire on a specific date. However, this approach created issues in the early days of crypto. Futures traded at a premium to the spot price, causing confusion among retail traders. The expiration of contracts also led to the closure of positions, regardless of the traders' intentions. BitMEX, founded in 2014, attempted to address these problems by shortening contract durations, but this ultimately proved insufficient. The perpetual swap, developed by Ben Delo and launched on BitMEX in 2016, eliminated the expiry date, creating a derivative contract that tracks the asset price indefinitely. This innovation introduced a structural challenge, as the contract price could deviate from the spot price without an expiry date to anchor it. BitMEX solved this issue through a funding rate mechanism, which has since become an industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market, based on the deviation between the perpetual swap price and the spot price. This self-correcting equilibrium helps to maintain price stability. The funding rate mechanism is now used by all major derivatives exchanges. Another key feature of perpetual swaps is leverage, which allows traders to control positions larger than their deposited capital. To manage the associated risks, exchanges use automated liquidation systems to close positions before they can incur losses. 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 perps has proven durable, with regulators exploring its application to traditional assets, and the CME potentially listing perpetual swaps on equities.