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

Perpetual swaps, or 'perps', have become the go-to trading instrument in the cryptocurrency market, with an estimated annual trading volume of $40 trillion to $50 trillion. These financial derivatives allow professional traders, hedge funds, and retail speculators to gain leveraged exposure to assets like bitcoin without actually owning them. Despite their widespread use, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to understand the traditional financial instruments that preceded them. In conventional finance, futures contracts provide leveraged exposure to an asset, with an agreement to buy or sell at a predetermined price on a specific date. However, when the contract expires, the position must be rolled over into a new contract. In the early days of cryptocurrency, this process created persistent issues, including a disconnect between futures prices and spot prices, known as basis. This confusion led to difficulties for retail traders seeking straightforward exposure to the market. The expiration of contracts also resulted in the automatic closure of 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 proved insufficient. The introduction of perpetual swaps in 2016 revolutionized the market by eliminating the expiry date altogether. This innovation created a derivative contract that could track the price of an asset indefinitely, without the need for rolling or expiry. Traders could now hold positions for any duration, from hours to years. To maintain a connection between the perpetual swap price and the underlying asset's spot price, a funding rate mechanism was introduced. 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 mechanism ensures that the perpetual swap price remains aligned with the spot price. The funding rate is calculated based on the deviation over the preceding eight-hour window, with higher deviations resulting in higher funding rates. This mechanism has become the industry standard, adopted by major derivatives exchanges worldwide. Another key feature of perpetual swaps is leverage, which allows traders to control positions significantly larger than their deposited capital. To manage the associated risks, exchanges employ automated liquidation systems, closing positions before they can incur losses. The reliability and speed of these systems have become a critical competitive differentiator in the market. Perpetual swaps have now become the primary venue for price discovery in the cryptocurrency market, with price movements often originating in perp markets before spreading to spot markets. The structure of perpetual swaps has proven so durable that regulators are now exploring its application to traditional assets, with the potential for listing perpetual swaps on equities.