Understanding Perps: The Evolution of Crypto's Most Popular Trading Instrument

Perpetual swaps, or 'perps', are a type of trading instrument that has revolutionized the crypto market, with an estimated $40 trillion to $50 trillion in annual volume. They have become the go-to product for professional traders, hedge funds, and retail speculators seeking leveraged exposure to assets like bitcoin without actually owning them. Despite their widespread use, the underlying mechanics of perps are not well understood. To grasp the concept of perps, it's essential to look at their origins. In traditional finance, futures contracts are used to gain leveraged exposure to an asset, but they come with an expiry date, after which the contract settles. In the early days of crypto, this created issues, such as futures trading at a premium to the spot price, known as basis, which caused confusion among retail traders. The expiry of contracts also led to positions being closed, regardless of the traders' intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but it wasn't until the introduction of perpetual swaps in 2016 that a solution was found. Perpetual swaps eliminated the expiry date, allowing traders to hold positions indefinitely. However, this created a new challenge: without an expiry date, the contract price could deviate from the spot price. To address this, a funding rate mechanism was introduced, where traders on opposite sides of the market exchange payments every eight hours. This mechanism has become the industry standard and is used by all major derivatives exchanges. The funding rate is calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. When the perpetual swap price deviates significantly from the spot price, the funding rate increases, making it more expensive for traders to hold their positions, which in turn pulls the price back toward the spot price. Another key feature of perpetual swaps is leverage, which allows traders to control positions larger than their deposited capital. To manage the risks associated with leverage, exchanges use automated liquidation systems to close positions before they can go negative. Perpetual swaps have become the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. The structure of perpetual swaps has proven durable, and regulators are now exploring their application to traditional assets.