Understanding Perpetual Swaps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, also known as perps, are a type of derivative contract that allows traders to gain leveraged exposure to the price of an asset, such as bitcoin, without actually owning it. They have become the go-to instrument for professional traders, hedge funds, and retail speculators, offering a more efficient and flexible way to trade than traditional futures contracts. To understand how perps work, it's helpful to look at their origins. In traditional finance, futures contracts are used to gain leveraged exposure to an asset, but they have an expiry date, which can create problems for traders who want to maintain their position. In the early days of crypto, this issue was particularly pronounced, with futures trading at a premium to the spot price of bitcoin, causing confusion among retail traders. BitMEX, a derivatives exchange, attempted to solve this problem by shortening contract durations, but it wasn't until the introduction of perpetual swaps in 2016 that a solution was found. Perpetual swaps eliminate the expiry date, allowing traders to hold a position for as long as they want. However, this created a new challenge: without an expiry date, the contract price could deviate significantly from the spot price of the underlying asset. To address this, a mechanism was introduced that exchanges payments between traders on opposite sides of the market every eight hours. This payment, known as the funding rate, is calculated based on the deviation of the perpetual swap price from the spot price and helps to keep the contract price in line with the underlying asset. The funding rate mechanism has become the industry standard and is used by all major derivatives exchanges. Another key feature of perpetual swaps is leverage, which allows traders to control positions that are significantly larger than their deposited capital. However, this also creates risk, and exchanges use automated liquidation systems to manage this risk and prevent traders' losses from exceeding their deposited margin. Perpetual swaps have become the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot. Their success has also attracted the attention of regulators, who are now exploring their application to traditional assets.