Understanding Perps: The Trading Instrument Revolutionizing Crypto

Perpetual swaps, also known as perps, are a type of derivative contract that has taken the crypto market by storm, allowing traders to gain leveraged exposure to asset prices without actually owning the underlying asset. Despite their widespread use, many people are still unclear about how they work. To grasp the concept of perps, it's helpful to look at their origins. In traditional finance, traders typically use futures contracts to gain exposure to an asset, which involves agreeing to buy or sell at a set price on a specific date. However, when the contract expires, it must be rolled over into a new one, which can be cumbersome. In the early days of crypto, this process created persistent issues, such as futures trading at a premium to the spot price, known as basis, and positions closing automatically when contracts expired. BitMEX, a derivatives exchange, attempted to address these problems by shortening contract durations, but ultimately developed a more innovative solution. The perpetual swap, introduced by BitMEX in 2016, eliminated the expiry date altogether, creating a contract that tracks the asset price indefinitely. This raised a new challenge: without an expiry date, the contract price could drift away from the spot price. To counter this, BitMEX implemented 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 mechanism has become the industry standard and is used by all major derivatives exchanges. Perpetual swaps also offer high leverage, allowing traders to control large positions with relatively small amounts of capital. However, this comes with significant risks, and exchanges use automated liquidation systems to manage these risks. 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. Their influence has become so significant that regulators are now exploring their application to traditional assets, with the potential for perpetual swaps on equities to be listed on major exchanges like the CME.