Understanding Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, or 'perps', are a dominant force in the crypto market, processing between $40 trillion to $50 trillion annually. They surpass spot trading and are the go-to instrument for professional traders, hedge funds, and retail speculators seeking leveraged exposure to assets like bitcoin without owning them. Despite their popularity, the inner workings of perps remain unclear. To grasp perps, it's essential to understand their predecessors. Traditional finance typically offers leveraged exposure through futures contracts, which expire on a set date. When the contract expires, traders must roll over their position to maintain it. In crypto's early days, this led to issues. Futures traded at a premium to the spot price, causing confusion among retail traders. Every time a contract expired, positions closed, regardless of the trader's intentions. BitMEX, founded by Arthur Hayes and Ben Delo in 2014, attempted to resolve this by shortening contract durations, but it wasn't enough. The perpetual swap, developed by Delo and launched by BitMEX in 2016, eliminated the expiry date, creating a derivative that tracks an asset's price indefinitely. This posed a structural challenge: without an expiry date, the contract price wouldn't naturally return to the spot price. BitMEX addressed this through a mechanism that has become the industry standard. Every eight hours, traders on opposite sides of the market exchange payments. If the perpetual swap price exceeds the spot price, long-position traders pay short-position traders. If the perpetual swap price is below spot, the payment is reversed. The exchange doesn't take a cut. The funding rate, which determines the payment amount, is calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight hours. This creates a self-correcting equilibrium, where high funding rates make it expensive to hold long positions, reducing demand and pulling the price back to 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 used by every major derivatives exchange. Perpetual swaps also offer leverage, allowing traders to control positions larger than their deposited capital. To manage the risk, exchanges use automated liquidation systems, which close positions before they can go negative, protecting the exchange from deficits. Perpetual swaps have become the primary venue for price discovery in crypto, with regulators exploring their application to traditional assets. What started as a workaround for crypto futures limitations has become one of the most traded financial products globally.