Perpetual contracts have become one of the most commonly used derivatives in the crypto market, with an annual trading volume reportedly reaching $40 trillion to $50 trillion, far exceeding that of the spot market. For professional traders, hedge funds, and retail investors with a high risk appetite, these products offer a way to gain exposure to the prices of assets such as Bitcoin and Ethereum without holding the physical assets.

Evolved from traditional futures

In traditional financial markets, leveraged exposure is typically achieved through futures contracts. Futures contracts stipulate the right to buy or sell an underlying asset at a specific price on a future date. Contracts must be settled upon expiration, and if traders wish to continue holding their positions, they must roll them over to the next contract.

The crypto market initially adopted this model, but problems quickly emerged. Bitcoin futures were consistently trading above spot prices, creating a basis that made it difficult for many retail investors to directly predict the true price direction. Furthermore, contract expiration forced the closing of positions, requiring traders to re-enter even if they didn't want to close their positions.

BitMEX promotes the implementation of perpetual contracts.

To address the expiration issue, BitMEX has continuously shortened contract cycles, gradually compressing them from quarterly contracts to monthly, weekly, and even 48-hour and 24-hour contracts, but the problem of position continuity has not been completely resolved.

In May 2015, BitMEX launched perpetual contracts. These products eliminate the expiration date, eliminating the need for traders to roll over contracts or settling times. Positions can be held for hours or even years. Essentially, they are derivative contracts without an expiration date.

Funding rates remain close to spot prices.

Without an expiration date, a new problem arises: how can the contract price continue to closely track the spot price if there is no anchor point for settlement at expiration?

The industry's answer is a funding rate mechanism. Typically, a funding payment occurs between long and short positions every 8 hours. When the perpetual contract price is higher than the spot price, it indicates stronger demand from long positions, and the longs pay the funding rate to the shorts; if the perpetual price is lower than the spot price, the shorts pay the longs. Exchanges usually do not take a cut from this payment.

• Perpetual prices are higher than spot prices: Long positions pay short positions
• Perpetual below spot: Shorts pay longs
• The greater the deviation: the higher the funding rate is usually.

Funding rates are adjusted based on the degree to which the perpetual price deviates from the spot price. The greater the deviation, the higher the rate. As a result, if the cost of long positions continues to rise, some traders will reduce their long exposure, pushing the contract price back closer to the spot price. Market makers will also sell perpetual contracts and buy spot contracts when the perpetual price is significantly higher than the spot price, profiting from the price difference and accelerating the price convergence.

Leverage and liquidation systems determine risk

Another key feature of perpetual contracts is leverage. Most platforms allow traders to control larger positions with less margin, with the specific leverage ratio varying depending on the platform and jurisdiction. BitMEX initially offered leverage up to 100x, meaning that a 1% fluctuation in the Bitcoin price could result in a nearly 100% change in profit or loss.

High leverage also necessitates that platforms have an automatic liquidation system. When losses approach the margin limit, the system automatically closes the positions to prevent the account from going negative and to reduce the risk of the exchange incurring losses due to margin calls. The speed and stability of the liquidation engine have long been crucial aspects of competition among derivatives platforms.

Perpetual markets dominate price discovery

As trading volume expands, perpetual contracts are no longer just an auxiliary tool, but one of the primary venues for price discovery in the crypto market. The article points out that when Bitcoin experiences rapid fluctuations, price changes often first appear in the perpetual market before spreading to the spot market.

This structure is also beginning to impact broader financial markets. A CoinDesk article mentions that US regulators are studying the introduction of similar mechanisms into traditional asset markets, and the CME Group may also explore perpetual stock contracts. Originally designed to address the shortcomings of crypto futures, this product has now become one of the most actively traded financial instruments globally.