Understanding Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, or 'perps', are a type of trading instrument that has revolutionized the crypto market. They allow traders to gain leveraged exposure to the price of assets like bitcoin without actually owning the underlying asset. With estimated annual volumes of $40 trillion to $50 trillion, perps have become the go-to instrument for professional traders, hedge funds, and retail speculators. However, despite their widespread use, the mechanics behind perps are not well understood. To grasp the concept of perps, it's essential to understand the traditional financial instruments that came before them. In traditional finance, traders typically use futures contracts to gain leveraged exposure to an asset. These contracts involve an agreement to buy or sell an asset at a set price on a specific date. When the contract expires, traders must roll it over into a new contract to maintain their position. In the early days of crypto, this process created problems. Futures contracts traded at a premium to the spot price of bitcoin, causing confusion among retail traders. Additionally, when contracts expired, positions were closed, regardless of whether traders wanted to maintain them. BitMEX, a derivatives exchange founded in 2014, attempted to solve this issue by shortening contract durations. However, none of these solutions were effective. The perpetual swap, developed by Ben Delo and launched on BitMEX in 2016, solved this problem by eliminating the expiry date altogether. This created a derivative contract that tracks the price of an asset indefinitely, with no settlement date, rolling, or expiry. Traders can hold positions for hours or years, making it an attractive option for those looking for flexible trading opportunities. The perpetual swap mechanism also includes a funding rate, which is a payment exchanged between traders on opposite sides of the market every eight hours. If the perpetual swap price is above the spot price, traders who are long pay traders who are short, and vice versa. This funding rate is calculated based on the deviation of the perpetual swap price from the spot price over the preceding eight-hour window. The further the deviation, the higher the funding rate. This creates a self-correcting equilibrium, where the funding rate adjusts to reduce demand and pull the price back towards the spot price. Market makers also play a crucial role in this process by shorting the perpetual swap and buying spot when a premium opens up, capturing the difference as profit. Leverage is another key feature of perpetual swaps. Most exchanges allow traders to control positions that are significantly larger than their deposited capital, with limits varying by platform and jurisdiction. To manage the risk associated with leverage, perpetual swap platforms use automated liquidation systems. If a trader's losses approach the value of their deposited margin, the system closes the position before it can go negative, protecting the exchange from absorbing the deficit. Perpetual swaps have become the primary venue for price discovery in crypto, with moves in the perp market often preceding moves in the spot market. The structure of perpetual swaps has proven durable, and regulators in the US are now exploring its application to traditional assets, with the CME potentially listing perpetual swaps on equities.