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

Perpetual swaps, or 'perps', are a dominant force in the crypto market, facilitating an estimated $40 trillion to $50 trillion in annual trading volume. They surpass spot trading in terms of popularity among professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin and other assets without directly owning them. Despite their widespread use, 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 are commonly used to gain leveraged exposure to an asset, involving an agreement to buy or sell at a predetermined price on a specific date. However, upon expiration, these contracts must be rolled over into new ones to maintain the position. In the early days of crypto, this approach led to persistent issues. Futures contracts traded at a premium to the spot price of bitcoin, causing confusion among retail traders. Moreover, positions were automatically closed when contracts expired, regardless of the traders' intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but this didn't provide a lasting solution. The introduction of perpetual swaps in 2016 revolutionized the market by eliminating expiration dates. This innovation allowed traders to hold positions indefinitely, creating a derivative contract that continuously tracks the price of an asset. The absence of an expiration date posed a structural challenge, as it didn't naturally push the contract price back towards the spot price. To counter this, a mechanism was implemented where payments are exchanged between traders on opposite sides of the market every eight hours. If the perpetual swap price exceeds the spot price, long-position traders pay short-position traders, and vice versa. This funding rate is calculated based on the deviation from the spot price over the preceding eight-hour window. The further the deviation, the higher the rate, creating a self-correcting equilibrium. When the funding rate becomes substantial, it becomes expensive for traders to maintain their positions, which in turn pulls the price back towards the spot price. Leverage is another key aspect of perpetual swaps, allowing traders to control positions significantly larger than their deposited capital. However, this also increases the risk, prompting exchanges to implement automated liquidation systems to manage potential losses. Perpetual swaps have become the primary venue for price discovery in crypto, with sharp bitcoin movements often originating in perp markets before spreading to spot markets. The structure of perpetual swaps has proven durable, and regulators are now exploring their application to traditional assets, potentially leading to the listing of perpetual swaps on equities.