Understanding Perpetual Swaps: The Driving Force Behind Crypto's Hottest Trading Instrument

Perpetual swaps, also known as 'perps', have become the go-to trading instrument for crypto enthusiasts, offering a unique way to gain leveraged exposure to assets like bitcoin without actually owning them. Despite their widespread adoption, the inner workings of perps remain shrouded in mystery. To grasp the concept of perps, it's essential to understand their origins. In traditional finance, futures contracts provide a means of gaining leveraged exposure to an asset, but they come with an expiration date, after which the contract settles. This created issues in the early days of crypto, as futures traded at a premium to the spot price, causing confusion among retail traders. The expiration of contracts also led to the closure of positions, regardless of the traders' intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but to no avail. The solution came in the form 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 extended periods. However, this created a new challenge: without an expiry date, the contract price could deviate significantly from the spot price. To mitigate this, a mechanism was introduced, where a payment is exchanged between traders on opposite sides of the market every eight hours. This payment, known as the funding rate, is calculated based on the deviation between the perpetual swap price and the spot price. The funding rate creates a self-correcting equilibrium, where the price of the perpetual swap is pulled back towards the spot price. Market makers accelerate this process by shorting the perpetual swap and buying spot, capturing the difference as profit. Leverage is another key feature of perpetual swaps, allowing traders to control larger positions with minimal capital. However, this also increases the risk, which is managed through automated liquidation systems. These systems close positions before they can incur significant losses, protecting the exchange from absorbing the deficit. Perpetual swaps have become the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot. The structure of perpetual swaps has proven durable, and regulators are now exploring its application to traditional assets, potentially listing perpetual swaps on equities.