Understanding Perpetual Swaps: The Backbone of Crypto Trading

Perpetual swaps, also known as perps, have emerged as the dominant force in crypto trading, with estimated annual volumes ranging from $40 trillion to $50 trillion. These financial instruments offer traders leveraged exposure to assets like bitcoin without requiring ownership, making them a favorite among professional traders, hedge funds, and retail speculators. Despite their widespread adoption, the inner workings of perps remain shrouded in mystery. To grasp the concept of perps, it's essential to understand the traditional financial instruments that preceded them. In conventional 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 created persistent issues in the crypto space, including basis and contract expiries that confused retail traders. The derivatives exchange BitMEX, founded by Arthur Hayes and Ben Delo in 2014, attempted to address these problems by shortening contract durations, but ultimately, a more innovative solution was needed. The perpetual swap, developed by Delo and launched on BitMEX in 2016, eliminated the expiry date, creating a derivative contract that tracks asset prices indefinitely. This groundbreaking design introduced a new challenge: without an expiry date, the contract price could drift away from the underlying asset's spot price. To mitigate this, BitMEX implemented a funding rate mechanism, which has become the industry standard. Every eight hours, traders on opposite sides of the market exchange payments, with the rate calculated based on the contract price's deviation from the spot price. This self-correcting mechanism ensures that the contract price remains aligned with the underlying asset. The funding rate is now used by every major derivatives exchange worldwide. Another key feature of perpetual swaps is leverage, allowing traders to control positions significantly larger than their deposited capital. To manage the associated risks, exchanges employ automated liquidation systems, which close positions before they can incur losses. The speed and reliability of these systems have become a critical differentiator in the market. Perpetual swaps have evolved into the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. The structure developed by Delo in 2016 has proven robust enough that regulators in the US are now exploring its application to traditional assets, with the potential for perpetual swaps on equities to be listed on the CME.