Uncovering Perps: The Crypto Trading Instrument Taking the World by Storm

Perpetual swaps, commonly referred to as 'perps', have emerged as the dominant force in the crypto market, with estimated annual trading volumes ranging from $40 trillion to $50 trillion. These financial instruments have surpassed spot trading in popularity, offering professional traders, hedge funds, and retail speculators a means to gain leveraged exposure to assets like bitcoin without actually owning them. Despite their widespread adoption, the inner workings of perps remain shrouded in mystery. To grasp the concept of perps, it's essential to understand their predecessors. In traditional finance, futures contracts are used to gain leveraged exposure to an asset, 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. Moreover, when contracts expired, positions were closed regardless of the traders' intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but to no avail. The perpetual swap, developed by Ben Delo and launched on BitMEX in 2016, revolutionized the market by eliminating the expiry date altogether. This innovative contract tracks the price of an asset indefinitely, with no settlement date, rolling, or expiry. Traders can now hold positions for hours or years, creating a new paradigm in the financial world. The absence of an expiry date, however, introduced a new challenge: without a natural anchor, the contract price could deviate significantly from the spot price of the underlying asset. To mitigate this, BitMEX introduced a mechanism that has become the industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market, with the rate calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. This funding rate creates a self-correcting equilibrium, where the price of the perpetual swap is pulled back toward the spot price. The role of leverage is also a defining feature of perpetual swaps. Most exchanges allow traders to control positions significantly larger than their deposited capital, with limits varying by platform and jurisdiction. To manage the risks associated with leverage, perpetual swap platforms 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 in the market. Perpetual swaps have now become the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot. The structure developed by Delo in 2016 has proven durable enough that regulators in the U.S. are exploring its application to traditional assets, with the CME potentially listing perpetual swaps on equities. What began as a solution to the limitations of crypto futures has evolved into one of the most traded financial products in the world.