Understanding Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, or 'perps,' have revolutionized the crypto market, offering traders leveraged exposure to assets like bitcoin without requiring ownership. Despite their widespread use, the inner workings of perps remain unclear to many. To grasp the concept of perps, it's essential to understand their origins. In traditional finance, futures contracts provide leveraged exposure to assets, but they come with an expiration date. When the contract expires, it must be rolled over into a new one. However, this approach created issues in the crypto space, where futures traded at a premium to the spot price, causing confusion among retail traders. The expiration of contracts also led to the automatic closure of positions, regardless of the traders' intentions. BitMEX, a derivatives exchange, addressed these problems by introducing perpetual swaps in 2016. This innovative instrument eliminated the expiry date, allowing traders to hold positions for any duration. The perpetual swap price is kept in check by a funding rate mechanism, which involves the exchange of payments between traders every eight hours. If the perpetual swap price deviates from the spot price, the funding rate is adjusted to encourage traders to bring the price back in line. This self-correcting mechanism has become an industry standard. Another key feature of perpetual swaps is leverage, which enables traders to control large positions with relatively small amounts of capital. However, this also increases the risk of significant losses, prompting exchanges to implement automated liquidation systems to manage this risk. Perpetual swaps have become the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. The success of perpetual swaps has even caught the attention of regulators, who are exploring their potential application to traditional assets.