Understanding Perpetual Swaps: The Hottest Crypto Trading Instrument

Perpetual swaps, also known as perpetual futures or 'perps,' have become the go-to trading instrument in the crypto market, with a massive volume of $40 trillion to $50 trillion being traded annually. They surpass spot trading in popularity and are the preferred choice of professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin or other assets without actually owning them. However, the inner workings of perpetual swaps are not well understood by many. To grasp the concept of perps, it's essential to understand their origins. In traditional finance, leveraged exposure to an asset is typically achieved through a futures contract, which is an agreement to buy or sell an asset at a predetermined price on a specific date. When the contract expires, it settles, and traders must roll over their position to maintain it. In the early days of crypto, this practice led to persistent issues. Futures contracts were traded at a premium to the spot price of bitcoin, causing confusion among retail traders who sought straightforward exposure to the asset's price. Moreover, when a contract 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 was not enough. The perpetual swap, developed by Ben Delo and launched on BitMEX in 2016, eliminated the expiry date, creating a derivative contract that tracks the price of an asset indefinitely. This innovation removed the need for settlement dates, rolling, and expiries, allowing traders to hold positions for any duration. However, this created a structural challenge, as the contract price would not naturally revert to the spot price without an expiry date. BitMEX solved this problem by introducing a funding rate mechanism, which has since become the industry standard. Every eight hours, a payment is made between traders on opposite sides of the market, with the rate calculated based on the deviation of the perpetual swap price from the spot price over the preceding eight-hour window. This self-correcting mechanism ensures that the contract price remains tied to the spot price. The funding rate is also influenced by market makers, who short the perpetual swap and buy spot when a premium opens up, capturing the difference as profit. Another key feature of perpetual swaps is leverage, which allows traders to control positions much larger than their deposited capital. To manage the associated risks, exchanges use automated liquidation systems, which close positions before they can become negative, protecting the exchange from potential losses. Perpetual swaps have become the primary venue for price discovery in crypto, with sharp moves in bitcoin's price often originating in perp markets before spreading to spot. The structure of perpetual swaps has proven durable, and regulators in the US are now exploring its application to traditional assets, with the CME potentially listing perpetual swaps on equities.