Understanding Perpetual Swaps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, also known as perps, are a type of derivative contract that has revolutionized the crypto market. They were first introduced by BitMEX in 2016 and have since become the go-to instrument for professional traders, hedge funds, and retail speculators seeking leveraged exposure to asset prices without actually owning the underlying asset. Despite their widespread use, the mechanics behind perps are not well understood. To grasp the concept of perps, it's essential to understand the traditional finance context. In traditional markets, leveraged exposure to an asset is typically achieved through a futures contract, which is an agreement to buy or sell an asset at a predetermined price on a specific date. However, this approach created problems in the crypto market, particularly with the concept of basis, where futures traded at a premium to the spot price of bitcoin, causing confusion among retail traders. The expiry of contracts also led to the closure of positions, regardless of the traders' intentions. BitMEX addressed these issues by introducing perpetual swaps, which eliminated the expiry date and created a derivative contract that tracks the price of an asset indefinitely. This innovation allowed traders to hold positions for any duration without the need for rolling or expiry. The perpetual swap mechanism involves a payment exchange between traders on opposite sides of the market every eight hours, with the rate calculated based on the deviation from the spot price. This self-correcting equilibrium ensures that the contract price remains aligned with the spot price. Another key feature of perps is leverage, which enables traders to control larger positions with limited capital. However, this also increases the risk, and exchanges use automated liquidation systems to manage this risk. Perpetual swaps have become the primary venue for price discovery in crypto, with regulators exploring their application to traditional assets. The structure of perps has proven durable, and their impact on the financial markets is expected to continue growing.