Understanding Perpetual Swaps: The Hottest Crypto Trading Instrument

Perpetual swaps, also known as 'perps', have become the go-to instrument for professional traders, hedge funds, and retail speculators seeking leveraged exposure to cryptocurrency prices without actually owning the assets. Despite their widespread use, the underlying mechanics of perps remain poorly understood. To grasp the concept of perps, it's essential to examine their origins. In traditional finance, futures contracts provide a means of gaining leveraged exposure to an asset, but these contracts expire on a specific date, requiring traders to roll over their positions. The early days of crypto saw similar issues with futures contracts, which traded at a premium to the spot price of bitcoin, causing confusion among retail traders. BitMEX, a derivatives exchange, addressed this problem by introducing perpetual swaps in 2016, eliminating the expiry date and creating a derivative contract that tracks the asset price indefinitely. This innovation posed a structural challenge, as the contract price could deviate from the spot price without an expiry date to anchor it. BitMEX solved this by introducing a funding rate mechanism, where traders on opposite sides of the market exchange payments every eight hours, based on the deviation between the perpetual swap price and the spot price. This self-correcting mechanism has become the industry standard. Perpetual swaps also offer high leverage, allowing traders to control large positions with relatively small amounts of capital. To mitigate the risks associated with high leverage, exchanges employ automated liquidation systems to close positions before they incur significant losses. Today, perpetual swaps have become the primary venue for price discovery in the crypto market, with regulators exploring their application to traditional assets.