Understanding Perpetual Swaps: The Dominant Force in Crypto Trading

Perpetual swaps, also known as perpetual futures, have revolutionized the crypto market by providing a unique trading instrument that allows traders to have leveraged exposure to the price of bitcoin or other assets without owning the underlying asset. The history of perpetual swaps dates back to 2016 when BitMEX launched this product, which was developed by Ben Delo. Prior to the introduction of perpetual swaps, traders used traditional futures contracts, which had limitations such as expiry dates and basis, a concept that refers to the difference between the futures price and the spot price of an asset. The perpetual swap contract eliminated the expiry date, allowing traders to hold positions for an indefinite period. However, this created a structural challenge, as the contract price could deviate from the spot price of the underlying asset. To address this issue, BitMEX introduced a funding rate mechanism, which involves exchanging payments between traders on opposite sides of the market every eight hours. The funding rate is calculated based on the deviation of the perpetual swap price from the spot price, and it creates a self-correcting equilibrium that pulls the price back toward the spot price. The funding rate mechanism has become an industry standard and is used by major derivatives exchanges worldwide. Another key feature of perpetual swaps is leverage, which allows traders to control positions that are significantly larger than their deposited capital. However, this creates risks for the exchange, and to manage these risks, perpetual swap platforms use automated liquidation systems. Perpetual swaps have become the primary venue for price discovery in crypto, and their impact is being felt beyond the crypto market, with regulators in the U.S. exploring their application to traditional assets.