Understanding Perpetual Swaps: The Dominant Force in Crypto Trading

Perpetual swaps, also known as perpetual futures, have emerged as the go-to instrument for professional traders, hedge funds, and retail speculators seeking leveraged exposure to crypto assets without actually owning them. Despite their widespread adoption, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to understand the traditional finance background. In conventional markets, 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. However, this approach created persistent issues in the crypto space. Futures contracts traded at a premium to the spot price of bitcoin, causing confusion among retail traders. Moreover, when contracts expired, positions were automatically closed, regardless of the traders' intentions. The derivatives exchange BitMEX, founded in 2014, attempted to address these issues by shortening contract durations, but to no avail. The breakthrough came with the introduction of perpetual swaps in 2016, which eliminated the expiry date altogether. This innovative contract allows traders to hold positions indefinitely, without the need for rolling or settlement. To maintain a link between the contract price and the spot price, a funding rate mechanism was implemented. Every eight hours, a payment is exchanged between traders on opposite sides of the market, with the rate calculated based on the deviation between the contract price and the spot price. This self-correcting mechanism has become the industry standard. Perpetual swaps also offer leverage, enabling traders to control larger positions with limited capital. However, this increased risk is managed through automated liquidation systems, which close positions before they can incur significant losses. Today, perpetual swaps are the primary driver of price discovery in the crypto market, with regulators exploring their application to traditional assets. The structure of perpetual swaps has proven resilient, and their influence extends beyond the crypto space, with the potential to shape the future of financial markets.