Understanding Perps: The Hottest Trading Instrument in Crypto

Perpetual swaps, also known as perpetual futures, have become the go-to trading instrument in the crypto market, with an estimated annual volume of $40 trillion to $50 trillion. These financial products have surpassed spot trading in popularity and are preferred by professional traders, hedge funds, and retail speculators who seek leveraged exposure to bitcoin and other assets without actually owning them. Despite their widespread use, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to understand the traditional finance context. Typically, investors gain leveraged exposure to an asset through a futures contract, which is an agreement to buy or sell at a predetermined price on a specific date. When the contract expires, it settles, and traders must roll over their position to maintain it. However, this approach created persistent issues in the early days of crypto. Futures contracts traded at a premium to the spot price of bitcoin, causing confusion among retail traders who sought straightforward exposure. Moreover, when contracts expired, positions were closed 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 sufficient solution. The perpetual swap, developed by Ben Delo and launched on BitMEX in 2016, resolved these problems by eliminating the expiry date. This created a derivative contract that tracks the price of an asset indefinitely, with no settlement date, rolling, or expiry. Traders can hold positions for any duration, from hours to years. However, this created a structural challenge: without an expiry date, the contract price wouldn't naturally revert to the spot price of the underlying asset. To address this, BitMEX introduced 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, long-position traders pay short-position traders, and vice versa. The exchange doesn't take a cut, and the payment rate, known as the funding rate, is calculated based on the deviation from the spot price over the preceding eight-hour window. This creates a self-correcting equilibrium, where high funding rates discourage traders from holding positions, pulling the price back toward the spot. Market makers accelerate this process by shorting the perpetual swap and buying spot when a premium opens up, capturing the difference as profit. The funding rate mechanism is now widely used by major derivatives exchanges. Another key feature of perpetual swaps is leverage. Most exchanges allow traders to control positions significantly larger than their deposited capital, with limits varying by platform and jurisdiction. To manage the risk, perpetual swap platforms use automated liquidation systems, which close positions before they can go negative, protecting the exchange from absorbing the deficit. Perpetual swaps have become the primary venue for price discovery in crypto, with sharp bitcoin moves often originating in perp markets before spreading to spot. The structure developed by Delo in 2016 has proven durable, and regulators in the U.S. are now exploring its application to traditional assets, with the CME potentially listing perpetual swaps on equities. What began as a workaround for crypto futures limitations has become one of the most traded financial products globally.