Understanding Perps: The Hottest Crypto Trading Instrument Explained

Perpetual swaps, commonly referred to as 'perps', have become the dominant trading instrument in the cryptocurrency market, facilitating an estimated $40 trillion to $50 trillion in annual trading volume. They surpass spot trading in popularity and are the go-to product for professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin and other cryptocurrencies without actually owning the underlying assets. 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 backdrop. Typically, traders 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. Upon expiration, the contract settles, and traders must roll over their positions to maintain them. In the early days of cryptocurrency, this approach created persistent issues. Futures contracts traded at a premium to the spot price of bitcoin, a phenomenon known as basis, which confused retail traders seeking straightforward exposure. Furthermore, when contracts expired, positions were automatically closed, regardless of the traders' intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but this proved insufficient. The perpetual swap, developed by Ben Delo and launched on BitMEX in 2016, revolutionized the market 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 now hold positions for any duration. However, this innovation introduced a new challenge: without an expiry date, nothing would naturally drive the contract price back to the spot price. BitMEX solved this by introducing a mechanism that has become the industry standard. Every eight hours, a payment is made 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 does not take a cut. The funding rate, which determines the payment amount, is calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour period. This creates a self-correcting equilibrium, where high funding rates discourage traders from holding positions, thus pulling the price back towards the spot price. Market makers accelerate this process by shorting the perpetual swap and buying spot when a premium emerges, capturing the difference as profit. The funding rate mechanism is now widely adopted by major derivatives exchanges. Another key feature of perpetual swaps is leverage. Exchanges often allow traders to control positions significantly larger than their deposited capital, with varying limits depending on the platform and jurisdiction. To mitigate the risks associated with high leverage, perpetual swap platforms employ automated liquidation systems. If a trader's losses approach the value of their deposited margin, the system closes the position to prevent the exchange from absorbing the deficit. The speed and reliability of this liquidation engine have become a key competitive differentiator in the market. Perpetual swaps have become the primary venue for price discovery in cryptocurrency, with price movements often originating in perp markets before spreading to spot markets. 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 potential listing of perpetual swaps on equities by the CME.