Understanding Perpetual Swaps: The Dominant Force in Crypto Trading

Perpetual swaps, or 'perps,' have become the go-to trading instrument in the crypto market, allowing users to gain leveraged exposure to assets like bitcoin without actually owning them. Despite their widespread use, the inner workings of perps remain somewhat mysterious. To grasp the concept of perps, it's essential to understand the traditional finance context from which they emerged. In the past, investors seeking leveraged exposure to an asset would typically use a futures contract, which involves an agreement to buy or sell the asset at a predetermined price on a specific date. However, this approach presented persistent issues in the crypto space, including the 'basis' phenomenon, where futures traded at a premium to the spot price, causing confusion among retail traders. The expiry of contracts also led to the automatic closure of positions, regardless of the traders' intentions. In response to these challenges, BitMEX, a derivatives exchange founded in 2014, experimented with shorter contract durations, but this didn't fully address the problem. The solution came in the form of perpetual swaps, which eliminated the expiry date altogether, enabling traders to hold positions for any length of time. This innovation created a new challenge: without an expiry date to anchor the contract price, it could drift away from the underlying asset's 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 helps maintain equilibrium by adjusting the funding rate based on the deviation between the perpetual swap price and the spot price. The funding rate is now a standard feature in the industry, used by all major derivatives exchanges. Another key aspect of perpetual swaps is leverage, which allows traders to control larger positions with relatively smaller amounts of capital. However, this also increases the risk of significant losses, prompting exchanges to implement automated liquidation systems to manage this risk. Today, perpetual swaps have become the primary venue for price discovery in the crypto market, with price movements often originating in perp markets before spreading to spot markets. The concept has proven so durable that regulators are now exploring its application to traditional assets, with the potential for perpetual swaps on equities to be listed on the CME.