Understanding Perpetual Swaps: The Hottest Crypto Trading Instrument Explained

Perpetual swaps, also known as perpetual futures or 'perps', are a dominant trading instrument in the crypto market, with an estimated annual volume of $40 trillion to $50 trillion. 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. Despite their widespread use, the mechanics behind perpetual swaps are not well understood. To grasp the concept of perps, it's essential to look at their predecessors. In traditional finance, leveraged exposure to an asset typically comes through a futures contract, which is an agreement to buy or sell at a set price on a specific date. When the contract expires, traders must roll over their position to maintain exposure. However, this approach created persistent issues in the crypto market, particularly with futures trading at a premium to the spot price of bitcoin. The perpetual swap, developed by Ben Delo and launched on BitMEX in 2016, addressed this problem by eliminating the expiry date. This created a derivative contract that tracks the price of an asset indefinitely, allowing traders to hold positions for any duration. To maintain price equilibrium, a funding rate mechanism was introduced, where traders on opposite sides of the market exchange payments every eight hours. The rate is calculated based on the deviation of the perpetual swap price from the spot price over the preceding eight-hour window. This self-correcting mechanism has become the industry standard. Perpetual swaps also offer leverage, allowing traders to control positions significantly larger than their deposited capital. To manage the associated risk, exchanges use automated liquidation systems to close positions before they can go negative. Today, perpetual swaps are the primary venue for price discovery in crypto, with regulators exploring their application to traditional assets. The structure developed by Delo in 2016 has proven durable, and perpetual swaps have become one of the most traded financial products globally.