Understanding Perps: The Crypto Trading Instrument Taking the World by Storm

Perpetual swaps, also known as perps, have emerged as the dominant force in the cryptocurrency market, offering traders a unique way to gain leveraged exposure to assets like bitcoin without actually owning them. Despite their widespread use, the inner workings of perps remain somewhat of a mystery. To grasp the concept of perps, it's essential to understand the traditional financial instruments that preceded them. In conventional finance, traders typically use futures contracts to gain leveraged exposure to an asset, which involves agreeing to buy or sell at a predetermined price on a specific date. However, this approach posed significant challenges in the early days of crypto. Futures contracts often traded at a premium to the spot price of bitcoin, causing confusion among retail traders. 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 didn't provide a lasting solution. The breakthrough came with the introduction of perpetual swaps, which eliminated the expiry date altogether. This innovative concept, developed by Ben Delo and launched on BitMEX in 2016, created a derivative contract that tracks the price of an asset indefinitely. The absence of an expiry date presented a structural challenge, as nothing would naturally force the contract price back toward the spot price. To overcome this, BitMEX implemented a mechanism that has since become the industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market, based on the deviation between the perpetual swap price and the spot price. This funding rate mechanism creates a self-correcting equilibrium, where the price of the perpetual swap is pulled back toward the spot price. The funding rate is calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. When the perpetual swap is trading above the spot price, long positions are charged a funding rate, making it expensive to hold the position and reducing demand. Conversely, when the perpetual swap is trading below the spot price, short positions are charged a funding rate. This mechanism has been widely adopted by major derivatives exchanges worldwide. Another key feature of perpetual swaps is leverage, which allows traders to control positions significantly larger than their deposited capital. However, this also increases the risk of significant losses, prompting exchanges to implement automated liquidation systems. These systems close positions before they can go negative, protecting the exchange from absorbing the deficit. The reliability and speed of these liquidation engines have become a crucial competitive differentiator in the market. Perpetual swaps have become the primary venue for price discovery in crypto, with sharp 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 CME potentially listing perpetual swaps on equities. What started as a workaround for the limitations of crypto futures has evolved into one of the most traded financial products globally.