Understanding Perpetual Swaps: The Dominant Force in Crypto Trading

Perpetual swaps, or 'perps', are a cornerstone of the crypto trading landscape, facilitating an estimated $40 trillion to $50 trillion in annual volume. They have surpassed spot trading in popularity, particularly among professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin and other assets without holding the underlying asset. Despite their widespread use, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to consider their predecessors. In traditional finance, leveraged exposure typically involves 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 posed persistent problems in the early days of crypto. Futures contracts traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure. Moreover, contract expirations resulted in the automatic closure of positions, regardless of the traders' 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 by BitMEX in 2016, revolutionized the market by eliminating the expiry date altogether. This created a derivative contract that tracks the asset price indefinitely, allowing traders to hold positions for any duration. The absence of an expiry date introduced a structural challenge, as nothing would naturally force the contract price back toward the spot price. To address this, BitMEX implemented a mechanism that has become the industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market, based on the deviation between the perpetual swap price and the spot price. This funding rate mechanism creates a self-correcting equilibrium, where the rate adjusts to reduce demand and pull the price back toward spot when the perpetual swap is trading at a premium. The role of leverage is another defining feature of perpetual swaps. Most exchanges offer traders the ability to control positions significantly larger than their deposited capital, with limits varying by platform and jurisdiction. To manage the risk associated with high leverage, perpetual swap platforms employ automated liquidation systems, which close positions before they can become negative and protect the exchange from absorbing the deficit. 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.