Uncovering Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, or 'perps,' have emerged as the go-to trading instrument in the crypto market, facilitating an estimated $40 trillion to $50 trillion in annual trading volume. This dwarfs spot trading and has become the preferred choice for professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin and other assets without holding the underlying asset. Despite their widespread adoption, the mechanics behind perps remain poorly understood. To grasp perps, it's essential to understand their origins. Traditional finance typically offers leveraged exposure to assets through futures contracts, which involve an agreement to buy or sell at a set price on a specific date. However, this approach created persistent issues in crypto's early days. 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 closed regardless of the traders' intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address this by shortening contract durations, but none of these efforts were sufficient. The perpetual swap, developed by Ben Delo and launched on BitMEX in 2016, revolutionized the market by eliminating the expiry date entirely. This created a derivative contract that tracks the price of an asset indefinitely, with no settlement date, rolling, or expiry. Traders can now hold positions for hours or years. To maintain equilibrium, a payment is exchanged between traders on opposite sides of the market every eight hours. If the perpetual swap price exceeds the spot price, long-position traders pay short-position traders, and vice versa. The exchange does not take a cut, and the funding rate is calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. This self-correcting mechanism has become the industry standard. Perpetual swaps also offer leverage, allowing traders to control positions significantly larger than their deposited capital. To manage the associated risks, exchanges use automated liquidation systems to close positions before they can incur losses. The speed and reliability of these systems have become a key differentiator in the market. Today, perpetual swaps have 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, and regulators are now exploring its application to traditional assets.