Understanding Perpetual Swaps: The Dominant Force in Crypto Trading

Perpetual swaps, also known as perpetual futures or 'perps,' have revolutionized the crypto market by providing a unique trading instrument that offers leveraged exposure to asset prices without the need for ownership. With an estimated $40 trillion to $50 trillion in annual trading volume, they have become the go-to instrument for professional traders, hedge funds, and retail speculators. Despite their widespread adoption, the inner workings of perpetual swaps remain poorly understood. To grasp the concept of perps, it's essential to understand the traditional finance context. In conventional markets, leveraged exposure to an asset is typically achieved through a futures contract, which involves an agreement to buy or sell an asset 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, this approach created persistent issues in the early days of crypto. Futures contracts 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. The derivatives exchange BitMEX, founded in 2014, attempted to address these problems by shortening contract durations, but this approach ultimately proved insufficient. The breakthrough came with the introduction of perpetual swaps, which eliminated the expiry date altogether. This innovative contract tracks the price of an asset indefinitely, allowing traders to hold positions for any duration without the need for rolling or expiry. The perpetual swap mechanism was developed by Ben Delo and launched on BitMEX in 2016. To maintain a link between the perpetual swap price and the underlying asset's spot price, a funding rate is exchanged between traders every eight hours. If the perpetual swap price deviates from the spot price, the funding rate is adjusted to incentivize traders to bring the price back in line. This self-correcting mechanism has become the industry standard. Perpetual swaps also offer leverage, enabling traders to control larger positions with limited capital. To mitigate the risks associated with leverage, exchanges employ automated liquidation systems to close positions before they incur significant losses. The reliability and speed of these systems have become a key differentiator in the market. Today, perpetual swaps are the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. The structure of perpetual swaps has proven so durable that regulators are now exploring its application to traditional assets, with the potential for listing perpetual swaps on equities.