Understanding Perpetual Swaps: The Hottest Crypto Trading Instrument

Perpetual swaps, also known as perpetual futures or 'perps', have become the go-to trading instrument in the crypto market, offering a unique way 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 finance background. In conventional markets, traders typically use futures contracts to gain leveraged exposure to an asset, which involves agreeing to buy or sell at a predetermined price on a specific date. However, this approach created persistent issues in the early days of crypto. Futures contracts often traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure. Moreover, when a contract expired, positions would automatically close, regardless of the trader's intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but this failed to provide a lasting solution. The breakthrough came with the introduction of perpetual swaps, which eliminated the expiry date altogether. This innovative contract tracks the price of an asset indefinitely, allowing traders to hold positions for any duration. The perpetual swap contract presented a new challenge: without an expiry date, the contract price could drift away from the underlying asset's spot price. To counter this, a funding rate mechanism was introduced, where traders on opposite sides of the market exchange payments every eight hours. This self-correcting mechanism ensures that the contract price remains aligned with 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. When the perpetual swap price exceeds the spot price, long-position traders pay short-position traders, and vice versa. This mechanism has become the industry standard, adopted by major derivatives exchanges worldwide. Another key feature of perpetual swaps is leverage, which enables traders to control positions significantly larger than their deposited capital. However, this also increases the risk of significant losses, prompting exchanges to implement automated liquidation systems to manage risk. These systems close positions before they can incur negative losses, protecting the exchange from potential deficits. Perpetual swaps have become the primary venue for price discovery in the crypto 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 perpetual swaps on equities to be listed on the CME.