Understanding Perpetual Swaps: The Dominant Force in Crypto Trading

Perpetual swaps, also known as 'perps,' have become the go-to instrument for traders seeking leveraged exposure to cryptocurrency prices without actually owning the assets. Despite their widespread adoption, the inner workings of perps remain somewhat mysterious. To grasp the concept of perps, it's essential to understand their origins. In traditional finance, futures contracts provide a means to gain leveraged exposure to an asset, but these contracts come with an expiration date. When the expiration date arrives, the contract settles, and traders must 'roll' their positions into new contracts to maintain exposure. However, this approach created issues in the early days of crypto. Futures contracts traded at a premium to the spot price of bitcoin, causing confusion among retail traders. Furthermore, when contracts expired, positions were automatically closed, regardless of the trader's intentions. BitMEX, a derivatives exchange launched in 2014, attempted to address these issues by shortening contract durations, but this didn't entirely resolve the problem. The breakthrough came with the introduction of perpetual swaps, which eliminated the expiration date altogether. This innovation allowed traders to hold positions indefinitely, without the need for rolling or settlement. To maintain a connection between the perpetual swap price and the underlying asset's spot price, a funding rate mechanism was implemented. Every eight hours, traders on opposite sides of the market exchange payments, with the rate determined by the deviation between the perpetual swap price and the spot price. This self-correcting mechanism has become an industry standard. Perpetual swaps also offer high leverage, enabling traders to control large positions with relatively small amounts of capital. To mitigate the risks associated with high leverage, exchanges employ automated liquidation systems, which close positions before they can incur significant losses. Today, perpetual swaps have become the primary venue for price discovery in the crypto market, with price movements often originating in perp markets before spreading to spot markets. The concept has proven so durable that regulators are now exploring its application to traditional assets, potentially leading to the listing of perpetual swaps on equities.