Funding rates are a highly correlated indicator to market sentiment and direction but remain relatively unfollowed in the digital asset world— we think this will change as the availability and size of the digital asset lending market increases and further institutional participants enter. Its something we follow closely and Joshua Green, Digital Asset Capital Management’s Head of Trading, prepared the following analysis this analysis in June 2018 which we thought we would share.
Whilst bitcoin (and other cryptocurrency) funding is a large topic that would take numerous articles to explore fully, in the below piece we set out a few basic principles and attempt to apply them to the historical bitcoin trading and lending market to gain some insight into price moves. Note, other aspects such as the relationship between futures basis and funding rates will be explored in subsequent pieces.
Broadly the following applies:
- When the market is bullish digital assets, USD is in short supply as traders borrow USD to finance leveraged long BTCUSD positions. This means USD rates > BTC rates;
- When the market is bearish digital assets, BTC is in short supply as traders borrow BTC to finance leveraged short BTCUSD positions. This means USD rates < BTC rates;
- When BTCUSD is bullish, you earn interest (funding) by shorting the BTCUSD Perpetual Swap on Bitmex (e.g a majority of 2017) and vice versa (e.g. a majority of 2018); (note to get a pure exposure to this a position has to be delta hedged); and
- When the funding rate is negative, shorts pay longs into the Bitmex snap; i.e. you should buy a delta hedged BTCUSD perpetual swap and earn the interest from the shorts on the snap (snaps occur every 8 hours and the inflow/outflow is calculated as funding = position value * funding rate); this generally occurs in a bearish market.
Analysis: Funding vs Price
In the chart below:
- The green line is the total sum of USD margin funding;
- The red line is the unused sum of USD margin funding; and
- The blue line is the funding rate.
What does this chart tell us?
- The average funding rate from the start of 2016 to the end of May 2018 is positive (smoothing out the large amount of volatility), this makes sense as the market is higher now than it was then and when the market is bullish USD rates > BTC rates;
- The funding rate tends to spike aggressively in a bull market, we are currently approaching levels on the downside where it may find some support (as we approach a zone of support on the daily charts);
- It rarely goes negative, any negative funding rate is a sign we are at historically extreme levels and the market is likely to represent good value from the long side; and
- The total sum of USD margin funding is positively correlated to BTC price movements, it still appears to have room to fall lower, we would suggest $600m-$400mn is a more ‘normal’ level.
If you line up the bitcoin price movements with the above chart (take our word for it as we have done it manually), it suggests the following:
- May 2017 — June 2017: there was a large spike in the USD funding rate and then a subsequent fall, however the market was still substantially higher after the subsequent fall. As the USD funding rate was rallying, BTC also rallied from ~$1400 to ~$2,200 while during the fall it effectively remained stable. However, it did stop rallying. We would suggest a weaker relationship can be explained by less leveraged trading at that time (and less market participation in general).
- October 2017 — Mid December 2017: this represented the last, sustained bull market in digital assets (and the bull market's most aggressive innings). This period was characterised initially by an aggressive spike in the USD funding rate, then a fall in November (which aligns with the November 2017 price pullback) then another large spike in December and a final fall into January (aligning with the markets price top). As opposed to in the May 2017-June 2017 period, In Oct 17 — Dec 17 bitcoin went from ~$4350 to $19,000 but also was accompanied by a significant rise in the total sum of USD margin funding (the green line in the above chart). This can be explained by the increasing participation of leveraged traders due to the bull market conditions, the increased market awareness by traders (or prospective traders) and the development of trading venues to cater to this demand. Importantly, while the funding rate had two distinct spikes, the total sum of USD margin funding continued on a fairly steady upwards trend — with hindsight perhaps indicating that dip in November was a good buy and that funding rates would also rise again.
- 2018 Bear Market: this has again been characterised by a positive correlation between funding metrics and market movements; a downtrend in the sum of USD margin funding and a very low and steady USD funding rate (aside from a sharp spike in mid-Feb) — up until the recent bull movement during April and into May (see the chart below). The sum of USD margin funding appears to have further to fall (bearish) while the funding rate is more neutral (though the risk may be for a further reduction).
The funding rate is currently negative — however, it is unlikely to be negative enough to have a significant impact on price. In reality we believe it most likely needs to be more than 5bps to attract meaningful interest in a short term trading sense (funding snaps are capped at 37.5bps). However, it is worth monitoring the rate to see if it blows out either direction as this can provide a leading indicator to market price movements especially in the short term. It should be noted that Arthur Hayes has demonstrated a general lack of predictive power between the funding rate and the swap over an 8 hour period, but that when the funding rate is extreme there is a tradeable signal in it over an 8 hour period (https://blog.bitmex.com/xbtusd-funding-mean-reversion-strategy/).
Below you can see the charted funding rate from end April to May 2018 on BTC, (apologies for the wrong way around X-Axis). This shows a spike in funding rates into the end of the recent price rally, and then steady, low rates throughout the recent selloff. One explanation for the below mean reversion (aside from market sentiment and general price movements) is the distortion experienced by the swap vs the average of GDAX and BitStamps, whereby market makers and other sophisticated market participants will use cash and carry arbitrage to bring this back into line with the exchanges as it blows out.
In short, it was high and volatile at the end of the price rally, and fell rapidly to a lower level (in rate and volatility terms) — much faster than the market. So perhaps there is some informational value in this — I.e. it was a leading indicator as to the latest leg lower in the market? Furthermore, this would also suggest that the swap (Bitmex) leads and then the exchange prices follow (of course this can change at any moment and also depends upon ones trading time frame and strategy). This is explained as; if the Bitmex perpetual swap leads (due to factors such as higher volumes) → then the swap trades rich vs exchange prices in a rally → funding goes higher → Bitmex longs get hurt on the 8hrly snaps as they have to pay funding to lenders (this makes sense as in bullish market you pay to be long and vice versa).
A Quick Update
Over the last 2 months there has been a shift in Bitmex funding whereby it appears to be broadly capped at +1bp. A full investigation of this is outside the scope of this piece, however one hypothesis could be that due to a combination of poor market sentiment and poor price action there is more demand to short the market. The follow on from this being that market participants (or a very large participant) are a) not expecting a meaningful move higher in funding and so possess higher conviction to be short funding and b) expect a capitulation in price and so are willing to quickly short the market via the perpetual swap whenever funding is positive.
This analysis and story was prepared by Joshua Green, Digital Asset Capital Management’s Head of Trading. He can be found on twitter @JoshuaGreenDACM
Disclaimer & Note: The above analysis does not represent investment advice. Funding markets can change quickly and past correlations may not be future correlations.