Crypto funding rates are crucial for maintaining the balance between the spot and perpetual futures markets. These rates are fees exchanged between traders holding long and short positions to keep perpetual contract prices aligned with spot prices. Calculated periodically, funding rates help mitigate discrepancies between contract values and actual market prices, fostering a stable trading environment. Positive rates indicate a bullish market, where longs pay shorts, while negative rates suggest a bearish trend, with shorts paying longs. Because understanding and effectively managing these rates is essential for traders to maximise profits and minimise risks in the volatile cryptocurrency landscape, we will comprehensively go through each part with explanation and detailed examples.
What are Funding Rates?
A crypto funding rate is a percentage of your position’s value that you pay to (or receive from) traders who have taken an opposite position to yours. These fees are typically calculated hourly or every eight hours.
To better understand the concept of funding rates, let’s first grasp some basics about different types of financial instruments.
- Spot Market: The actual buying and selling of BTC for immediate delivery.
- Futures Market: Contracts to buy and sell BTC at a predetermined price at a specified time in the future.
- Perpetual Futures Market: Similar to the futures market, but without an expiry date, allowing traders to hold positions indefinitely.
Now let’s take Bitcoin as an example. Say you buy a BTC futures contract today at $70,000. On the contract expiration date, the Bitcoin spot rate (the actual price of the BTC at that time) has increased to $73,000, so you must sell it and could yield $3,000. However, if the Bitcoin value falls, let’s say to $66,000, presumably, by the expiration date, you would lose $4,000.
However, if you opt for a perpetual futures contract (or perpetuals in short), you’re not forced to take delivery of the Bitcoin. You can still bet on the future price, and the contract never expires. In perpetual futures trades, there are two sorts of bet:
- A long position is a bet on the price going up
- A short position is a bet on the price falling down
If you’re a trader who expects prices to rise, you will be part of payment exchanges with those who predict these prices will decline, and vice versa. The payment made by traders of different positions is calculated based on their use of leverage and the difference between the market’s current index price and the perpetual contract’s price.
How do Funding Rates work?
Funding rates work quite simply, in fact. Generally, shorts pay longs if the trend is up, and longs pay shorts if the trend is down. On most exchanges, funding rate payment intervals are often of 1, 4, or 8 hours.
In a traditional futures contract, buyers and sellers in the market adjust the contract price toward the spot market price by taking long or short positions, engaging in arbitrage trading continuously throughout the day.
Perpetuals, however, do not have an expiration date, so their prices often differ from spot prices. Without an end date, there is no market of buyers and sellers for these contracts and, therefore, no arbitrage opportunity for the contract value itself.
This creates a dilemma: In a bullish market, the perpetual contract price for a cryptocurrency is typically higher than the spot price, and the opposite is true in a bearish market. How does that work for trades? The answer is it doesn’t. It’s an untradeable mess.
Crypto funding rates solve this issue by keeping the prices of perpetual contracts closer to the spot prices, thus making trading feasible.
Calculating Funding Rates
There are two parts of a funding rate:
- The interest rate (denoted by I) is fixed and set by the exchange. However, it might vary for different cryptocurrencies
- The premium index (denoted by P) changes based on how far the perpetual price is from the spot price.
The funding rate (F) is calculated using the premium index and a clamp function, which is designed to set a maximum interest rate (for most exchanges). Here’s an example (note that I in this case is 0.03%):
F=P+clampI-P,0.05%, -0,05%
In the equation above, the clamp function ensures that the Funding Rate remains within the range of ±0.05% by limiting the difference between the Interest Rate (I) and the Premium Index (P).
When the funding rate is positive when the perpetual is trading above the spot price. Long traders pay a fee to short traders. Conversely, the funding rate is negative when the perpetual is trading below the spot price. In this case, shorts pay a fee to longs.
Apply this to our previous example with Bitcoin. Assume that you start with a $70,000 Bitcoin long and the funding rate is positive at 0.05%, so you will pay $35 to keep that position open for 8 hours. If the funding rate turns negative, the shorts pay the longs instead.
Let’s take a look at an example of a funding rates charts:
Interpreting Funding Rates
A high funding rate often signals strong bullish sentiment in the market, indicating that traders holding long positions on a particular crypto asset are willing to pay a high fee to maintain their positions. Conversely, a low or negative funding rate suggests bearish sentiment, with traders holding short positions willing to pay a fee to keep their positions, showing confidence in a further decline in the cryptocurrency’s price.
Why do Crypto Exchanges need Funding Rates?
Funding rates, specifically the fees they generate, create market incentives to keep perpetual contract prices close to the spot price. These fees encourage short or long sellers to close their positions or open positions on the opposite side of the trade. When traders open new positions, they must decide whether to pay a funding fee or receive a payment from other traders.
These incentives help align the contract price with the spot price. Without funding fees, perpetual contract prices would deviate significantly from the spot price, resulting in an upward spread during bullish markets and a downward spread during bearish markets. Funding fees maintain order in the trading environment.
In practice, funding fees achieve this by managing pressure on the profits and increasing liquidation risks:
- Profits: When the funding rate increases, it puts more pressure on the profits of the traders who are paying the funding fee. A higher funding rate raises the value of the fee, which can reduce the profitability of traders on the paying side of the trade. Conversely, traders on the receiving side of the fee, who are typically incurring losses, benefit as the funding fee they receive helps offset some of their losses.
- Liquidation Risk: Funding rates not only affect profits but also pose a liquidation risk if traders are not fully aware of them or do not take them into account when entering a trade. A high funding fee reduces the trader’s margin money, bringing them closer to their liquidation value. As the fee consumes the trader’s margin, the available margin required to keep the position open decreases, increasing the risk of liquidation.
