Understanding Perps: The Cryptocurrency Trading Instrument

Perpetual swaps, also known as perpetual futures, have become the go-to trading instrument in the cryptocurrency market, with an estimated annual volume of $40 trillion to $50 trillion. They surpass spot trading and offer professional traders, hedge funds, and retail speculators leveraged exposure to bitcoin and other assets without requiring ownership. Despite their widespread use, the underlying mechanics of perps remain poorly understood. To comprehend perps, it's essential to consider their predecessors. In traditional finance, leveraged exposure to an asset typically involves a futures contract, which is an agreement to buy or sell at a fixed price on a specific date. When the contract expires, it settles, and traders must roll over their positions to maintain them. In the early days of cryptocurrency, this practice led to persistent issues. Futures contracts traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure. Additionally, when contracts expired, positions closed regardless of the traders' intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address this issue by shortening contract durations, but these efforts were insufficient. The perpetual swap, developed by Ben Delo and launched on BitMEX in 2016, resolved the problem by eliminating the expiry date. This created a derivative contract that tracks the asset's price indefinitely, with no settlement date, rolling, or expiry. Traders can hold positions for hours or years. However, this created a structural challenge: without an expiry date, the contract price wouldn't naturally revert to the spot price. BitMEX addressed this through 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. The funding rate is calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. This creates a self-correcting equilibrium, where high funding rates make it expensive to hold long positions, reducing demand and pulling the price back toward 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 used by every major derivatives exchange. Perpetual swaps also feature leverage, allowing traders to control positions larger than their deposited capital. To manage the associated risk, exchanges use automated liquidation systems, which close positions before they can become negative, protecting the exchange from deficits. Perpetual swaps have become the primary venue for price discovery in cryptocurrency, with bitcoin price movements often 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.