Understanding Perpetual Swaps: The Driving Force Behind Crypto's Trading Landscape

Perpetual swaps, or 'perps', have become the backbone of the cryptocurrency market, facilitating an estimated $40 trillion to $50 trillion in annual trading volume. These financial instruments provide traders with leveraged exposure to assets like bitcoin without the need for actual ownership. Despite their widespread use, the inner workings of perpetual swaps remain somewhat of a mystery. To grasp the concept of perps, it's essential to understand their predecessors. In traditional finance, futures contracts are used to gain leveraged exposure to an asset, with the contract expiring on a specific date. However, this model posed significant challenges in the early days of cryptocurrency trading. Futures contracts often traded at a premium to the spot price of bitcoin, causing confusion among retail traders. Furthermore, when a contract expired, positions were automatically closed, regardless of the trader's intentions. In an effort to address these issues, BitMEX, a derivatives exchange founded in 2014, experimented with shorter contract durations, but to no avail. The breakthrough came with the introduction of perpetual swaps in 2016, which eliminated the expiry date altogether. This innovation allowed traders to hold positions indefinitely, without the need for rolling over contracts. 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, adopted by major derivatives exchanges worldwide. Another key feature of perpetual swaps is leverage, which enables traders to control large positions with limited capital. To mitigate the risks associated with high leverage, exchanges employ automated liquidation systems to close positions before they incur significant losses. The reliability and speed of these systems have become a crucial competitive factor in the market. Today, perpetual swaps are the primary venue for price discovery in the crypto space, with price movements often originating in perp markets before spreading to spot markets. The concept of perpetual swaps has proven so durable that regulators are now exploring its application to traditional assets, with the potential for the CME to list perpetual swaps on equities.