Uncovering Perps: The Ultimate Guide to Crypto's Most Popular Trading Instrument

Perpetual swaps, also known as perps, have become the go-to trading instrument in the crypto market, with estimated annual volumes ranging from $40 trillion to $50 trillion. They surpass spot trading in popularity and are the preferred choice among professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin or other assets without actually owning them. Despite their widespread use, the underlying mechanics of perps remain poorly understood. To grasp the concept of perps, it's essential to understand their predecessors. In traditional finance, leveraged exposure to an asset is typically achieved through futures contracts, which involve an agreement to buy or sell at a predetermined price on a specific date. When the contract expires, it settles, and traders must roll over their positions to maintain them. However, this approach created persistent issues 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, when contracts expired, positions were automatically closed, regardless of the traders' intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but this didn't provide a lasting solution. The introduction of perpetual swaps in 2016 revolutionized the market by eliminating expiry dates. This innovative contract type, developed by Ben Delo, enables traders to hold positions indefinitely without the need for rolling or settlement. However, this created a new challenge: without an expiry date, the contract price might not naturally revert to the spot price of the underlying asset. To address this, BitMEX implemented a mechanism that has become the industry standard. Every eight hours, a payment is made between traders on opposite sides of the market, with the rate determined by the deviation between the perpetual swap price and the spot price over the preceding eight-hour period. This self-correcting mechanism, known as the funding rate, helps maintain equilibrium. When the funding rate is high, it becomes costly for traders to hold positions, reducing demand and pulling the price back toward the spot price. Market makers accelerate this process by shorting perpetual swaps and buying spot when a significant premium arises, capturing the difference as profit. The funding rate mechanism is now widely used across major derivatives exchanges. Perpetual swaps also offer leverage, allowing traders to control positions that exceed their deposited capital. To manage the associated risks, exchanges employ automated liquidation systems, which 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 are 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, with the potential for the CME to list perpetual swaps on equities. What began as a workaround for crypto futures has evolved into one of the most widely traded financial products globally.