Understanding Perpetual Swaps: The Driving Force Behind Crypto's Hottest Trading Instrument

Perpetual swaps, also known as perpetual futures or 'perps', have become the dominant trading instrument in the crypto market, facilitating an estimated $40 trillion to $50 trillion in annual trading volume. They surpass spot trading in popularity and are the go-to product for professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin and other assets without directly owning them. Despite their widespread use, the underlying mechanics of perpetual swaps are not well understood. 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. Upon expiration, the contract settles, and traders must roll over their positions to maintain them. In the early days of crypto, this approach created persistent issues. Futures contracts 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 traders' intentions. BitMEX, founded by Arthur Hayes and Ben Delo in 2014, attempted to address these issues by shortening contract durations, but this proved insufficient. The introduction of perpetual swaps in 2016 revolutionized the market by eliminating the expiry date altogether. This created a derivative contract that tracks the asset's price indefinitely, with no settlement date, rolling, or expiry. Traders can now hold positions for any duration. However, this innovation presented a structural challenge: without an expiry date, the contract price might not naturally revert to the spot price of the underlying asset. BitMEX resolved this by implementing a funding rate mechanism, which has become the industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market, based on the deviation of the perpetual swap price from the spot price. This self-correcting equilibrium ensures that the contract price remains aligned with the spot price. The funding rate is calculated based on the deviation over the preceding eight-hour window, and the exchange does not take a cut. The other defining feature of perpetual swaps is leverage. Most exchanges allow traders to control positions significantly larger than their deposited capital, with varying limits depending on the platform and jurisdiction. To manage the associated risks, perpetual swap platforms employ automated liquidation systems, which close positions before they can incur negative balances, protecting the exchange from potential deficits. Perpetual swaps have become the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. The structure developed by Delo in 2016 has proven durable, and regulators in the U.S. are now exploring its application to traditional assets, with the potential listing of perpetual swaps on equities by the CME.