Uncovering Perps: The Cryptocurrency Trading Instrument That's Taking the World by Storm

Perpetual swaps, often referred to as 'perps', have emerged as the go-to trading instrument in the cryptocurrency market, facilitating an estimated $40 trillion to $50 trillion in annual trading volume. These swaps have surpassed spot trading in popularity, offering professional traders, hedge funds, and retail investors a means of gaining leveraged exposure to bitcoin and other cryptocurrencies without actually owning the underlying assets. Despite their widespread adoption, the inner workings of perpetual swaps remain somewhat of a mystery. To grasp the concept of perps, it's essential to understand the traditional financial instruments that preceded them. In conventional finance, investors typically gain leveraged exposure to an asset through futures contracts, which are agreements to buy or sell an asset at a predetermined price on a specific date. When the contract expires, it must be rolled over into a new contract to maintain the position. However, this approach created persistent issues in the early days of cryptocurrency trading. Futures contracts often traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure to the asset's price movements. Furthermore, when contracts expired, positions were automatically closed, regardless of the trader's intentions. 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 the expiry date altogether. This innovative contract allows traders to maintain positions indefinitely, without the need for rolling or settlement. However, this created a new challenge: without an expiry date, the contract price could deviate significantly from the underlying asset's spot price. To mitigate this, BitMEX introduced a funding rate mechanism, which has since become an industry standard. Every eight hours, traders on opposite sides of the market exchange payments, with the rate determined by the contract's deviation from the spot price over the preceding eight-hour period. This self-correcting mechanism helps maintain equilibrium and prevents the contract price from straying too far from the underlying asset's value. The funding rate is calculated based on the contract's deviation from the spot price, with larger deviations resulting in higher funding rates. This creates a powerful incentive for traders to adjust their positions, as holding a long position with a high funding rate can become costly. Market makers accelerate this process by shorting the perpetual swap and buying the underlying asset, capturing the difference as profit. The other key feature of perpetual swaps is leverage. 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 high leverage, perpetual swap platforms employ automated liquidation systems. If a trader's losses approach the value of their deposited margin, the system closes the position before it can become negative, protecting the exchange from absorbing the deficit. The speed and reliability of these liquidation engines have become a crucial differentiator in the competitive exchange landscape. Perpetual swaps have become the primary venue for price discovery in the cryptocurrency market, with price movements often originating in perp markets before spreading to spot markets. The structure developed by Delo in 2016 has proven remarkably durable, with regulators in the US now exploring its application to traditional assets, such as equities.