Uncovering Perps: The Cryptocurrency Trading Instrument Taking the World by Storm

Perpetual swaps, commonly referred to as 'perps', have become the go-to trading instrument in the cryptocurrency market, with an estimated annual trading volume of $40 trillion to $50 trillion. They overshadow spot trading and are the preferred choice for professional traders, hedge funds, and individual speculators seeking leveraged exposure to assets like bitcoin without actually owning them. Despite their widespread adoption, the underlying mechanics of perps remain poorly understood. To grasp the concept of perps, it's essential to understand the traditional financial instruments that preceded them. In conventional finance, investors typically gain leveraged exposure to an asset through futures contracts, which involve an agreement to buy or sell at a predetermined price on a specific date. Upon expiration, the contract is settled, and traders must roll over their positions to maintain exposure. However, this approach created persistent issues in the early days of cryptocurrency. Futures contracts often traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure. Moreover, 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 failed to provide a lasting solution. The introduction of perpetual swaps in 2016 revolutionized the market by eliminating expiry dates altogether. This innovative contract type, developed by Ben Delo, allows traders to hold positions indefinitely without the need for rolling or settlement. The absence of an expiry date presented a new challenge: without a natural anchor, the contract price could drift away from the underlying asset's spot price. To mitigate this, BitMEX implemented a funding rate mechanism, which has since become an industry standard. Every eight hours, traders on opposite sides of the market exchange payments, with the rate determined by the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. This self-correcting mechanism ensures that the contract price remains aligned with the underlying asset's value. The funding rate is calculated based on the degree of deviation, with larger deviations resulting in higher rates. When long positions become expensive to maintain due to high funding rates, demand decreases, and the price is pulled back toward the spot price. Market makers accelerate this process by shorting perpetual swaps and buying spot assets when a significant premium arises, capturing the difference as profit. Leverage is another defining feature of perpetual swaps, allowing traders to control large positions with relatively small amounts of capital. To manage the associated risks, exchanges employ automated liquidation systems, which close positions before they can incur negative balances. The speed and reliability of these systems have become a key differentiator in the market. Perpetual swaps have become the primary venue for price discovery in cryptocurrency, with significant price movements often originating in perp markets before spreading to spot markets. The structure developed by Delo in 2016 has proven resilient, and regulators are now exploring its application to traditional assets, with the potential for perpetual swaps to be listed on equities.