Understanding Perpetual Swaps: The Most Traded Crypto Instrument

Perpetual swaps, also known as 'perps', are a type of derivative contract that has revolutionized the crypto market. They allow traders to gain exposure to the price of assets like bitcoin without actually owning them, with estimated annual trading volumes ranging from $40 trillion to $50 trillion. Despite their widespread use, the inner workings of perps remain unclear to many. To grasp the concept of perps, it's essential to understand the traditional financial instruments that preceded them. In conventional finance, traders typically use futures contracts to gain leveraged exposure to an asset, which involves agreeing to buy or sell at a predetermined price on a specific date. However, this approach posed significant problems in the early days of crypto. 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. Furthermore, when these contracts expired, traders' positions would automatically close, regardless of their intentions. The derivatives exchange BitMEX, founded in 2014, attempted to address these issues by shortening contract durations, but this didn't provide a lasting solution. The breakthrough came with the introduction of perpetual swaps, which eliminated the expiry date altogether. This innovative contract type, developed by Ben Delo and launched on BitMEX in 2016, enables traders to hold positions for any duration without the need for settlement dates, rolling, or expiries. A crucial mechanism underlying perps is the funding rate, which is exchanged between traders on opposite sides of the market every eight hours. If the perp price exceeds the spot price, long-position traders pay short-position traders, and vice versa. This self-correcting mechanism helps maintain equilibrium and prevents the perp price from deviating significantly from the spot price. The funding rate is calculated based on the deviation between the perp price and the spot price over the preceding eight-hour period. Perpetual swaps also offer high leverage, allowing traders to control large positions with relatively small amounts of capital. However, this increased leverage also amplifies potential losses, prompting exchanges to implement automated liquidation systems to mitigate risk. These systems rapidly close positions when a trader's losses approach the value of their deposited margin, protecting the exchange from potential deficits. The efficiency and reliability of these liquidation engines have become a key differentiator among exchanges. Today, perpetual swaps have become the primary venue for price discovery in the crypto market, with price movements often originating in perp markets before spreading to spot markets. The concept of perps has proven so resilient that regulators are now exploring its application to traditional assets, potentially leading to the listing of perpetual swaps on equities by the CME.