Understanding Perpetual Swaps: The Dominant Trading Instrument in Crypto

Perpetual swaps, also known as 'perps,' have become the go-to trading instrument for professional traders, hedge funds, and retail speculators in the crypto market, with an estimated annual volume of $40 trillion to $50 trillion. These swaps enable traders to gain leveraged exposure to the price of bitcoin or other assets without actually owning the underlying asset. Despite their widespread use, the mechanics behind perpetual swaps are not well understood. To grasp the concept of perps, it's essential to understand the traditional finance context. In the past, leveraged exposure to an asset was typically achieved through a futures contract, which is an agreement to buy or sell an asset at a set 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 created issues in the crypto market, such as futures trading at a premium to the spot price of bitcoin, known as basis, which caused confusion among retail traders seeking straightforward exposure. The expiry of contracts also led to the closure of positions, regardless of the traders' intentions. BitMEX, a derivatives exchange, attempted to address these issues by shortening contract durations, but this didn't provide a lasting solution. The perpetual swap, developed by Ben Delo and launched by BitMEX in 2016, resolved these problems by eliminating the expiry date. This created a derivative contract that tracks the price of an asset indefinitely, allowing traders to hold positions for any duration. The absence of an expiry date introduced a structural challenge, as there was no natural mechanism to push the contract price back toward the spot price. To address this, BitMEX introduced a funding rate mechanism, which has since become an industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market, based on the deviation of the perpetual swap price from the spot price. This self-correcting mechanism helps maintain equilibrium. The funding rate is calculated based on the deviation over the preceding eight-hour window, and it becomes more expensive for traders to hold positions when the funding rate is high, which in turn pulls the price back toward the spot price. Market makers also contribute to this process by shorting the perpetual swap and buying spot when a premium opens up, capturing the difference as profit. Leverage is another key feature of perpetual swaps, allowing traders to control positions significantly larger than their deposited capital. To manage the associated risks, exchanges use automated liquidation systems, which close positions before they can become negative, protecting the exchange from potential losses. The speed and reliability of these liquidation engines have become a competitive differentiator among exchanges. Perpetual swaps have now 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 its application to traditional assets, with the potential for the CME to list perpetual swaps on equities.