Understanding Perps: The Dominant Trading Instrument in Crypto

Perpetual swaps, or 'perps', are a pivotal trading instrument in the cryptocurrency market, facilitating an estimated $40 trillion to $50 trillion in annual volume. They overshadow spot trading and serve as the go-to product for professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin or other assets without direct ownership. Despite their widespread use, the underlying mechanics of perps remain poorly understood. To grasp perps, it's essential to consider their predecessors. In traditional finance, futures contracts provide leveraged exposure to an asset, with an agreement to buy or sell at a specified price on a particular date. Upon expiration, the contract settles, and traders must roll their positions into the next contract if they wish to maintain them. In the early days of crypto, this process created persistent issues. Futures contracts traded at a premium to the spot price of bitcoin, known as basis, confusing retail traders seeking straightforward exposure. Moreover, positions would close upon contract expiration, regardless of the trader's intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, transitioning from quarterly to monthly, weekly, 48-hour, and eventually 24-hour expiries, but these efforts were insufficient. The perpetual swap, developed by Ben Delo and launched by BitMEX in 2016, resolved these problems by eliminating the expiry date altogether. This created a derivative contract that tracks the asset's price indefinitely, with no settlement date, rolling, or expiry. Traders can maintain positions for any duration, from hours to years. However, this innovation introduced a structural challenge: without an expiry date to anchor the contract price, it would not naturally revert to the spot price of the underlying asset. BitMEX addressed this through a mechanism that has become the industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market. If the perpetual swap price exceeds the spot price, indicating excess demand for long positions, long traders pay short traders. Conversely, if the perpetual swap price is below spot, the payment is reversed. The exchange does not take a cut. The funding rate, which determines the payment rate, is calculated based on the deviation of the perpetual swap price from the spot price over the preceding eight-hour window. A greater deviation results in a higher funding rate, creating a self-correcting equilibrium. When long positions incur a substantial funding rate, it becomes costly to hold, reducing demand and pulling the price toward spot. Market makers accelerate this process by shorting the perpetual swap and buying spot when a meaningful premium emerges, capturing the difference as profit. The funding rate mechanism is now widely adopted by major derivatives exchanges. Leverage is another defining feature of perpetual swaps. Most exchanges allow traders to control positions significantly larger than their deposited capital, with varying limits depending on the platform and jurisdiction. At its peak, BitMEX offered leverage of up to 100 times, meaning a 1% move in bitcoin's price could yield a 100% gain or loss on a fully leveraged position. To mitigate the risk, perpetual swap platforms employ automated liquidation systems. If a trader's losses approach the value of their deposited margin, the system closes the position before it can become negative, protecting the exchange from absorbing the deficit. The speed and reliability of the liquidation engine have been a key competitive differentiator and remain crucial to how exchanges compete today. Perpetual swaps have become the primary venue for price discovery in crypto, with significant bitcoin moves often originating in perp markets before spreading to spot. The structure developed by Delo in 2016 has proven robust enough that U.S. regulators are now exploring its application to traditional assets, with the CME potentially listing perpetual swaps on equities. What began as a workaround for the limitations of crypto futures has evolved into one of the most widely traded financial products globally.