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

Perpetual swaps, commonly referred to as 'perps,' have become the go-to trading instrument in the cryptocurrency market, boasting an estimated annual trading volume of $40 trillion to $50 trillion. They outshine spot trading and serve as the preferred choice for professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin and other assets without directly owning them. Despite their widespread adoption, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to examine their predecessors. In traditional finance, investors typically gain leveraged exposure to an asset through futures contracts, which involve an agreement to buy or sell at a predetermined price on a specific date. Upon expiration, the contract is settled, and traders must roll over their positions to maintain them. 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, a phenomenon known as basis, which confused retail traders seeking straightforward exposure. Moreover, the expiration of contracts would automatically close positions, regardless of the traders' intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these problems by shortening contract durations, but this proved insufficient. The introduction of perpetual swaps in 2016 revolutionized the landscape by eliminating expiry dates altogether. This innovation enabled traders to hold positions indefinitely, thereby creating a derivative contract that tracks the price of an asset without interruption. The absence of an expiry date, however, posed a significant structural challenge: without a natural anchor, the contract price could drift away from the spot price of the underlying asset. To mitigate this, a mechanism was developed wherein traders on opposing sides of the market exchange payments every eight hours. If the perpetual swap price exceeds the spot price, indicating excess demand for long positions, long traders pay short traders, and vice versa. This funding rate is calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. The further the deviation, the higher the funding rate, creating a self-correcting equilibrium that pulls the price back toward the spot price. Another defining feature of perpetual swaps is leverage. Most exchanges allow traders to control positions that far exceed their deposited capital, with limits varying by platform and jurisdiction. To manage the associated risks, perpetual swap platforms employ automated liquidation systems, which close positions before they can incur negative balances, thereby protecting the exchange. The efficiency and reliability of these liquidation engines have become a key differentiator in the market. Perpetual swaps have now become the primary venue for price discovery in crypto, with significant price movements often originating in perp markets before spreading to spot markets. The structure developed in 2016 has proven resilient, and regulators are now exploring its application to traditional assets, with the potential listing of perpetual swaps on equities by the CME.