Crypto Funding Rate Arbitrage Basics
Crypto Casinos(Exchanges lol) are different from your average Stock Markets. With a unique range of derivatives to gambol(trade, excuse my language) on, a lot of inefficiencies occur, one of them being the Funding Rate Arbitrage. This trade can be performed on the Perpetual Futures of the underlying tokens.
What are Perpetual Futures?
We should first understand what a futures contract is. A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. This means that the price of a quarterly futures contract becomes the same as the price of the underlying asset at settlement, i.e. when the contract expires.
Perpetual futures, on the other hand, don’t have an expiration date at all. They function just like other futures contracts in that they enable traders to use leverage, but the main difference is that they never expire. This raises an interesting question: if perpetuals never settle, then what stops their price from deviating from the underlying asset price by a lot, especially when market sentiment is very bullish or bearish? This would defeat the main purpose of the futures contract and it would start behaving as an individual entity not pegged to the underlying.
What are funding rates?
The funding rate consists of periodic payments between traders. These payments are made to maintain the perpetual futures contract price reasonably close to the asset price in the spot market.
If the funding rate is positive, the market is bullish, at which time long traders should pay short traders. Conversely, when the funding rate is negative, the market is bearish, so short traders must pay long traders.
As I said earlier, the funding rate maintains the equilibrium between buyers and sellers. The more different the futures contract from the spot price, the higher the funding rate. Gamblers(Investors lol) can take advantage of the funding rate claiming it by betting against the trade. Hence, futures prices will approach spot price.
Binance Funding Rate Mechanism
Funding rates are calculated several times a day, depending on the exchange. I am personally a CZ maximalist (also due to Govt. regulations) , I will only discuss about Binance.
Funding rates consist of two main components: interest rate and premium, recalculated every 8 hours.
- Interest rate: fixed at 0.03% daily (0.01% per funding interval), except BNBUSDT and BNBBUSD contracts with zero interest rate.
- Premium: varies according to the price difference between the perpetual contract and spot price.
Funding rate exchanged between buyers and sellers. During the funding rate cycle (every 8 hours), the premium index will be calculated every minute and the time-weighted average value will be used to calculate the funding rate.
Arbitrage Techniques
Spot and Perpetual Market Funding Rate Arbitrage
If funding rate gets too positive, short the futures and long the underlying(spot) and enjoy the funding yield and vice-versa.
Most of the times, funding rate arbs is not where you would want to park your capital(which can be utilized for better trades). You only wanna do this when the yields are juicy enough or if you do not have a +EV system to trade these markets.
Those -0.03% and below peaks are when you wanna arb tf out of these markets. Usually the most volatile assets will have the most appealing funding rates.
Below is the code snippet for retrieving funding rate data for all assets on Binance and sort them in ascending order.
Will attach link to github at the end so chill.
Cross Exchange Funding Rate Arbitrage
This is the more giga-brain technique with really thin margins, so wouldn’t suggest to do but here it is anyways.
The gap between funding rates between any two exchanges could be exploit by the combination of a long position on one exchange with lower rate and a short position on another exchange with higher rate to collect the difference.
To even execute this would require all of my brain cells and more. It would require a pristine OEMS(google it) . And all my OEMS are super basic so let’s leave this for the big boys.
Risks involved
Since you are long as well as short the same asset at the same time, you are fully hedged and delta neutral. But that’s not all there is. There are other risks involved as well.
Liquidation Risk: Your position in the Perpetual contracts can be liquidated in case any violent moves happen so margin maintenance considerations have to be taken in account.
Liquidity Issues: After you have collected the sweet funding yield, you also have to close your remaining positions at the exact same price so that no other losses occur. If the exchange you are using isn’t liquid enough then, well you are f****d cause slippage will take away all of the Arbitrage profits and more. This is a much bigger risk while performing cross-exchange arbs hence only for the giga-brains.
Exchange Insolvency Risk: Yes, lol. Crypto Exchanges(both CEXs and DEXs) are just 24/7 casinos. You never know when the Govt. decides on a new policy or if they run away with all of your magic internet money.
Final Note
If you made it this far, then congrats you have a higher attention span than 90% of people around you. I will try to write at least one article per week , so if you found this useful then consider following my medium account.
None of what I have written in this article is Financial Advice. Yes, none of it. If you blindly follow an article written by an 18 y/o Uni kid without doing any due diligence of your own, then well what can I say more.
If the feds ever come here:
