Understanding Perps: The Crypto Trading Instrument Everyone's Talking About

Perpetual swaps, or 'perps', are a dominant force in the crypto market, handling an estimated $40 trillion to $50 trillion in volume annually. They surpass spot trading in popularity and are the go-to instrument for professional traders, hedge funds, and retail speculators seeking leveraged exposure to assets like bitcoin without actually owning them. However, the inner workings of perps remain somewhat mysterious to many. To grasp the concept of perps, it's helpful to look at their predecessors. In traditional finance, leveraged exposure to an asset typically involves a futures contract - an agreement to buy or sell at a predetermined price on a specific date. When the date arrives, the contract expires, and traders must roll their position into the next contract if they wish to maintain it. Early on in crypto, this process caused persistent issues. Futures contracts were often traded at a premium to the spot price of bitcoin, known as basis, which confused retail traders seeking straightforward exposure. Moreover, when a contract expired, positions would automatically close, regardless of the trader's intentions. BitMEX, founded by Arthur Hayes and Ben Delo in 2014, attempted to address these issues by shortening contract durations, moving from quarterly to monthly, weekly, 48-hour, and eventually 24-hour expiries, but none of these adjustments were sufficient. The perpetual swap, developed by Delo and launched by BitMEX in 2016, solved these problems by eliminating the expiry date altogether. This created a derivative contract that could track an asset's price indefinitely, with no settlement date, rolling, or expiry. Traders could hold positions for any duration. However, this introduced a structural challenge: without an expiry date to anchor the contract price, it wouldn't naturally revert to the spot price of the underlying asset. BitMEX addressed this through a mechanism that has since become an industry standard. Every eight hours, a payment is made between traders on opposite sides of the market. If the perpetual swap price exceeds the spot price, indicating high demand for long positions, long traders pay short traders. If the perpetual swap price is below spot, the payment is reversed. The exchange doesn't take a cut. The payment rate, known as the funding rate, is calculated based on the deviation of the perpetual swap price from the spot price over the preceding eight hours. The greater the deviation, the higher the rate. This creates a self-correcting equilibrium. When long positions are charged a substantial funding rate, it becomes expensive to hold, reducing demand and pulling the price back toward spot. Market makers accelerate this process by shorting the perpetual swap and buying spot when a premium opens up, capturing the difference as profit. The funding rate mechanism is now widely used by major derivatives exchanges. Leverage is another defining feature of perpetual swaps. Exchanges allow traders to control positions much larger than their capital, with limits varying by platform and jurisdiction. At its peak, BitMEX offered leverage of up to 100 times, meaning a 1% move in bitcoin's price could result in a 100% gain or loss on a fully leveraged position. To manage this risk, perpetual swap platforms use automated liquidation systems. If a trader's losses approach their deposited margin, the system closes the position before it can go negative, protecting the exchange. The speed and reliability of this liquidation engine were key differentiators in the early market and remain crucial today. Perpetual swaps have become the primary venue for price discovery in crypto, with sharp bitcoin moves often originating in perp markets before spreading to spot. The structure developed by Delo in 2016 has proven durable, with regulators in the U.S. exploring its application to traditional assets, potentially listing perpetual swaps on equities. What started as a workaround for crypto futures limitations has become one of the world's most traded financial products.