A Newbie’s Guide to Understanding Crypto Funding Rates
Now, while perpetual futures have a learning curve that is not typically suitable for those new to the crypto world, even the most inexperienced users can benefit greatly from these types of investments if they arm themselves with the necessary knowledge and determination.
Today, I’ll go over a subset of the perpetual futures market. We’ll be discussing funding rates.
So, what are Funding rates?
Funding rates are periodic payments made to either long or short traders based on the difference in perpetual contract markets and spot prices. It prevents lasting divergence in the price of both markets.
What factors influence the funding rate?
To fully understand the fundamentals of funding rates, we must first understand how futures contracts work.
A futures contract is essentially an agreement between two parties to buy and/or sell their assets at a later date for a specific price. Both traditional and perpetual futures contracts are known as derivatives, meaning that their value is derived from or directly linked to the value of another asset.
Traditional futures have an expiry date. And as the contract approaches its maturity date, people begin arbitraging, causing prices to converge and expire close to the spot price.
On the other hand, Future contracts in the crypto world have values that are directly related to the value of their underlying tokens. These perpetual futures contracts allow crypto traders to hold positions with no expiration date, which means the contracts never settle. People can hold them indefinitely until they close or are liquidated.
The funding rate comprises two components: the interest rate and the premium. The interest rate is usually fixed while the premium varies according to the price difference between the perpetual contract and mark price.
The price of the perpetual contract and the mark price may diverge during periods of high volatility. In such cases, the premium rises or falls accordingly.
A wide spread implies a high premium. A low premium, on the other hand, indicates a narrow spread between the two prices.
When the funding rate is positive, the perpetual contract price is higher than the mark price, and traders who are long pay for short positions. A negative funding rate, on the other hand, indicates that perpetual prices are lower than the mark price, implying that short positions pay for longs.
The funding isn’t a magical number, it has a very simple method of calculation for almost all exchanges. the funding rate is simply: Funding Rate = *[Interest Rate — Premium Index] + Premium Index *a clamp function is applied with ceil/floor as 0.05% and -0.05%
The funding rate is not a magical number. It is calculated in a very simple manner for almost all exchanges.
Funding Rate (F) = Premium Index (P) + clamp (Interest Rate (I) — Premium Index (P), 0.05%, -0.05%)
A clamp function is used, with a ceiling and floor of 0.05% and -0.05%, respectively. Hence, if (I — P) is within +/-0.05% then F = P + (I — P) = I.
To understand the formula better, consider the following: Interest rate contracts are traded with a base and a quote currency (e.g., BTC — base, USD — quote), and the interest rate is a simple calculation between them that goes as follows:
Interest quote index = the borrowing rate for the quote currency
Interest base index = the borrowing rate for the base currency
Funding interval = the periodic intervals in which rates are recalculated
Let’s now try to make these even simpler by using an example.
Binance and Bybit have USD rates at 0.06% and the BTC rate at 0.03%, so the difference is roughly 0.03%. The funding interval for most exchanges is 8 hours, so the interest rate = (0.06–0.03)/(24/8) = 0.01% (the magical number).
But how do we enforce convergence when spot and perpetual prices are so far apart?
We enforce it by employing the adorable premium index.
Max = f (x)
Impact Bid Price = The average fill price used to execute the bid price’s Impact Margin Notional.
Impact Ask Price = the average fill price to execute the Impact Margin Notional on the ask
Index Price = the asset’s index price
The Impact Margin Notional (IMN) for perp contracts is the notional available to trade with 200 USDT (binance) of initial margin (quote in USDT) and is used to determine the average impact bid or ask and how deep it is in the order-book IMN = 200 / Initial margin rate at maximum leverage.
Consider the following example from Binance:
If maximum leverage for btcusdt is 125x and the Initial Margin Rate is 0.8%, then the IMN is 25,000 USDT (200 USDT / 0.8%). It means that the system will take an IMN of 25,000 USDT every minute in the order book to measure the average Impact Bid/Ask price.
As a result, the premium index varies, influencing the funding rate.
Take note of how the premium index varies greatly on days of high volatility/big moves.
If the majority of traders are long, funding rates will be positive, and long traders will pay shorts to balance out the contracts once the time period expires. The same thing happens vice-versa.
To look at funding rates across exchanges I use Coinglass. It is a great website for observing funding rates and many other metrics as well.
It is also important to note that trading with funding rates is not as simple as negative = short squeeze because traders are stupid; positive = go up because whales are buying. Funding rates by themselves are NOT buy/signals, but when combined with other analyses, they can allow you to make more confident trades.
Reference materials:
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