Understanding Perpetual Swaps: The Dominant Force in Crypto Trading

Perpetual swaps, or 'perps', are a cornerstone of the crypto trading landscape, facilitating an estimated $40 trillion to $50 trillion in annual volume. These financial derivatives enable traders to gain leveraged exposure to assets like bitcoin without actually owning them. Despite their widespread use, the inner workings of perps remain somewhat mysterious. To grasp the concept of perps, it's essential to understand the traditional finance backdrop. Typically, leveraged exposure to an asset is achieved through a futures contract, which is an agreement to buy or sell at a predetermined price on a specific date. When the contract expires, it must be rolled over into a new contract to maintain the position. However, in the early days of crypto, this process created persistent issues. Futures contracts often traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure. Furthermore, when contracts expired, positions were automatically closed, regardless of the trader's intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but this didn't provide a lasting solution. The introduction of perpetual swaps in 2016 revolutionized the landscape by eliminating the expiry date altogether. This innovation enabled traders to hold positions indefinitely, without the need for rolling or expiry. To maintain a connection between the perpetual swap price and the underlying asset's spot price, a funding rate mechanism was introduced. Every eight hours, a payment is made between traders on opposite sides of the market, with the rate calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. This self-correcting mechanism helps to maintain equilibrium in the market. Perpetual swaps also offer leverage, allowing traders to control larger positions with lower capital requirements. However, this increased leverage is managed through automated liquidation systems, which protect the exchange from potential losses. Today, perpetual swaps have become the primary venue for price discovery in crypto, with regulators exploring their application to traditional assets. The structure of perpetual swaps has proven resilient, and their influence extends beyond the crypto market, with the potential to shape the future of financial trading.