Unveiling Perps: The Most Traded Crypto Instrument Explained

Perpetual swaps, or 'perps', have become the go-to instrument for traders seeking leveraged exposure to cryptocurrency prices without owning the underlying asset. With estimated annual trading volumes ranging from $40 trillion to $50 trillion, they overshadow spot trading and are the preferred choice of professional traders, hedge funds, and retail speculators alike. Despite their widespread adoption, 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, with an agreement to buy or sell at a predetermined price on a specific date. However, this approach posed persistent problems in the early days of crypto. Futures contracts traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure. Furthermore, contract expirations resulted in unwanted position closures. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but this proved insufficient. The perpetual swap, developed by Ben Delo and launched on BitMEX in 2016, revolutionized the market by eliminating expiry dates. This innovation created a derivative contract that tracks asset prices indefinitely, allowing traders to hold positions for extended periods. The absence of an expiry date presented a structural challenge, as nothing would naturally push the contract price back toward the spot price. To address this, BitMEX introduced a mechanism that has since become an industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market, with the direction and rate of this payment, known as the funding rate, determined by the deviation between the perpetual swap price and the spot price. This self-correcting mechanism creates an equilibrium, where high funding rates discourage traders from holding positions, thereby pulling prices back toward spot. Market makers accelerate this process by shorting perpetual swaps and buying spot when premiums arise, capturing the difference as profit. Leverage is another defining feature of perpetual swaps, with most exchanges offering traders the ability to control large positions with limited capital. To mitigate the risks associated with high leverage, exchanges employ automated liquidation systems, which close positions before they can incur significant 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 sharp price movements often originating in perp markets before spreading to spot. The structure developed by Delo 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.