Uncovering Perps: The Crypto Trading Instrument Taking the World by Storm

Perpetual swaps, commonly referred to as 'perps', have become the driving force behind the crypto market, facilitating an estimated $40 trillion to $50 trillion in annual trading volume. These financial instruments have surpassed spot trading in popularity, offering professional traders, hedge funds, and retail speculators a means to gain leveraged exposure to bitcoin and other assets without actual ownership. Despite their widespread adoption, the underlying mechanics of perps remain poorly understood. To grasp the concept of perps, it's essential to examine their predecessors. In traditional finance, leveraged exposure to an asset is typically achieved through futures contracts, which involve an agreement to buy or sell at a predetermined price on a specific date. Upon expiration, the contract is settled, and traders must roll over their positions to maintain exposure. 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 seeking straightforward exposure. Moreover, contract expirations resulted in the automatic closure of positions, regardless of the traders' intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these problems by shortening contract durations, but this proved insufficient. The introduction of perpetual swaps in 2016 revolutionized the market by eliminating expiry dates altogether. This innovative contract type, developed by Ben Delo, enables traders to maintain positions indefinitely, without the need for rolling or settlement. The absence of an expiry date, however, created a structural challenge: without a natural anchor, the contract price could deviate significantly from the underlying asset's spot price. To mitigate this, BitMEX implemented a funding rate mechanism, which has since become an industry standard. Every eight hours, traders on opposing sides of the market exchange payments, with the rate calculated based on the contract's deviation from the spot price over the preceding eight-hour period. This self-correcting mechanism helps maintain equilibrium, as high funding rates discourage traders from holding positions, thereby reducing demand and pulling the price back toward the spot price. Market makers accelerate this process by shorting the perpetual swap and buying spot when a significant premium arises, capturing the difference as profit. The other defining feature of perpetual swaps is leverage, which allows traders to control larger positions with minimal capital. To manage the associated risks, exchanges employ automated liquidation systems, closing positions before they incur significant losses. The efficiency and reliability of these systems have become a key differentiator in the market. Perpetual swaps have evolved into the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot. The structure developed by Delo in 2016 has proven resilient, and regulators are now exploring its application to traditional assets, with the potential for perpetual swaps to be listed on equities.