Unlocking the Secrets of Perpetual Swaps: The Most Traded Financial Product in Crypto

Perpetual swaps, also known as perps, have become the go-to trading instrument in the crypto market, with an estimated annual volume of $40 trillion to $50 trillion. These financial derivatives allow professional traders, hedge funds, and retail speculators to gain leveraged exposure to the price of bitcoin or other assets without actually owning them. Despite their widespread use, the underlying mechanics of perps remain poorly understood. To grasp the concept of perps, it's essential to look at their origins. In traditional finance, traders typically use futures contracts to gain leveraged exposure to an asset, which involves an agreement to buy or sell at a predetermined price on a specific date. However, this approach created persistent issues in the crypto market, including a premium on futures contracts compared to spot prices, known as basis, and the automatic closure of positions when contracts expired. The derivatives exchange BitMEX addressed these problems by introducing perpetual swaps in 2016, which eliminated the expiry date and enabled traders to hold positions indefinitely. This innovation created a structural challenge, as the contract price could deviate from the spot price without an expiry date to anchor it. BitMEX solved this issue by implementing a funding rate mechanism, where traders on opposite sides of the market exchange payments every eight hours, based on the deviation between the perpetual swap price and the spot price. This self-correcting mechanism has become the industry standard. Perpetual swaps also offer high leverage, allowing traders to control large positions with relatively small amounts of capital. To manage the associated risks, exchanges use automated liquidation systems to close positions before they become unprofitable. Today, perpetual swaps are the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. The success of perps has even caught the attention of regulators, who are now exploring their potential application to traditional assets.