Understanding Perpetual Swaps: The Dominant Crypto Trading Instrument

Perpetual swaps, or 'perps', are a type of derivative contract that has become the primary trading instrument in the crypto market, with an estimated annual volume of $40-50 trillion. They allow traders to gain leveraged exposure to the price of assets like bitcoin without actually owning the asset. Despite their widespread use, the mechanics behind perps are not well understood. To grasp perps, it's helpful to understand the traditional finance context. Typically, traders use futures contracts to gain leveraged exposure to an asset, which involves agreeing to buy or sell at a set price on a specific date. However, when the contract expires, traders must roll their position into a new contract to maintain exposure. In the early days of crypto, this process created issues, such as futures trading at a premium to the spot price, known as basis, which confused retail traders seeking straightforward exposure. Additionally, when contracts expired, positions would close regardless of the trader's intentions. BitMEX, a derivatives exchange, attempted to address these issues by shortening contract durations, but this didn't solve the problem. The perpetual swap, developed by Ben Delo and launched by BitMEX in 2016, resolved these issues by eliminating the expiry date. This created a derivative contract that tracks the asset price indefinitely, with no settlement date, rolling, or expiry. Traders can hold positions for any duration, from hours to years. A key challenge arose: without an expiry date, the contract price wouldn't naturally return to the spot price. BitMEX addressed this by introducing a funding rate mechanism, where traders on opposite sides of the market exchange payments every eight hours. If the perp price exceeds the spot price, long traders pay short traders, and vice versa. The exchange doesn't take a cut, and the funding rate is calculated based on the price deviation over the preceding eight-hour window. This creates a self-correcting equilibrium, where high funding rates make it expensive to hold positions, reducing demand and pulling the price back to spot. Market makers accelerate this process by shorting perps and buying spot when a premium opens up, capturing the difference as profit. The funding rate mechanism is now used by major derivatives exchanges worldwide. Perpetual swaps also offer leverage, allowing traders to control larger positions with deposited capital. To manage the associated risk, exchanges use automated liquidation systems to close positions before they go negative. The speed and reliability of these systems have become a key competitive differentiator. Perpetual swaps have become the primary venue for price discovery in crypto, with price movements typically originating in perp markets before spreading to spot. The structure developed by Delo in 2016 has proven durable, and regulators are now exploring its application to traditional assets.