Understanding Perpetual Swaps: The Crypto Market's Dominant Trading Instrument

Perpetual swaps, or 'perps', are a type of derivative contract that has become the primary instrument for trading in the crypto market, with an estimated annual volume of $40 trillion to $50 trillion. They provide traders with leveraged exposure to the price of cryptocurrencies like bitcoin, without the need to own the underlying asset. Despite their widespread use, the mechanics of perpetual swaps are not well understood. To grasp how they work, it's helpful to consider the traditional finance context, where leveraged exposure typically involves futures contracts with set expiration dates. In the early days of crypto, this approach created issues, such as basis and contract expirations, which confused traders. BitMEX addressed these problems by introducing perpetual swaps, which eliminate the need for an expiration date. Instead, a funding rate is used to keep the contract price in line with the spot price of the underlying asset. This mechanism involves exchanging payments between traders on opposite sides of the market every eight hours, based on the deviation between the perpetual swap price and the spot price. The funding rate creates a self-correcting equilibrium, where high rates reduce demand and pull the price back toward spot. Perpetual swaps also offer high leverage, allowing traders to control large positions with relatively small amounts of capital. To manage the risks associated with this leverage, exchanges use automated liquidation systems to close positions before they can become negative. Today, perpetual swaps are the primary venue for price discovery in the crypto market, with regulators exploring their potential application to traditional assets.