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

Perpetual swaps, or 'perps', have become the go-to instrument for professional traders, hedge funds, and retail speculators seeking leveraged exposure to cryptocurrency prices without holding the underlying assets. Despite their widespread use, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to consider their predecessors. In traditional finance, futures contracts provide leveraged exposure to assets, but they come with an expiry date, after which the contract is settled. This created issues in the early days of crypto, as futures traded at a premium to spot prices, causing confusion among traders. The expiry 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 this proved insufficient. The breakthrough came with the introduction of perpetual swaps, which eliminated the expiry date altogether. This innovation allowed traders to hold positions for any duration, from hours to years. However, this created a new challenge: without an expiry date, the contract price could deviate significantly from the spot price. To mitigate this, a funding rate mechanism was introduced, where traders on opposite sides of the market exchange payments every eight hours. This self-correcting mechanism has become the industry standard. The funding rate is calculated based on the deviation of the perpetual swap price from the spot price over the preceding eight-hour window. When the perpetual swap price exceeds the spot price, long positions are charged a funding rate, making it more expensive to hold the position and reducing demand. This, in turn, pulls the price back toward the spot price. Market makers accelerate this process by shorting the perpetual swap and buying spot, capturing the difference as profit. Leverage is another defining feature of perpetual swaps, allowing traders to control positions significantly larger than their deposited capital. To manage the associated risks, exchanges use automated liquidation systems, which close positions before they can incur losses. The speed and reliability of these systems have become a key competitive differentiator. 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, with the potential for listing perpetual swaps on equities.