What is the funding rate for perpetual swaps?

The funding rate is the secret sauce behind perpetual swap contracts, crypto’s most popular trading product. But what is it? How does it affect your trading strategy?

The funding rate is how the price of a perpetual swap is kept close to the price of the underlying asset. It works by sending periodic payments between long and short traders. This is critical: a poorly designed funding rate makes perpetual swaps riskier, more volatile, and costlier.

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tl;dr

The funding rate enables a perpetual swap to closely track its underlying by balancing supply and demand between the buy (long) and sell (short) sides of the market. The funding rate is similar to either a fee or a rebate, that traders pay or are paid to hold their positions, depending on which side of the market they are on. On BitMEX, for example, if the BTC/USD perpetual swap (XBTUSD) is trading above the spot price of Bitcoin, the funding rate would be positive. This means that long traders would pay short traders (discouraging long positions and incentivizing short positions). On the other hand, if the BTC/USD perpetual swap is trading below the spot price of Bitcoin, the funding rate would be negative. This means that short traders would pay long traders (discouraging short positions and encouraging long positions, thus raising the perpetual swap’s price up towards the underlying).

if perpetual_swap_price > underlying_price => funding_rate is positive
if perpetual_swap_price < underlying_price => funding_rate is negative

The funding rate is paid directly from long traders to short traders, or vice versa; the exchange itself doesn’t take a cut.

While in theory you could stand to gain from receiving funding rate payments, generally speaking, the funding rate mechanics work against popular trades. For example, if most people are long the BTC perpetual swap contract and you also want to be long BTC, you are most likely paying a funding rate fee to all the shorts who are keeping the perpetual swap price in line. Bitcoin historically has been a largely upward-trending/bullish market, so long traders have typically paid the funding fee to short traders.

Funding rates are defined by fixed intervals (e.g. BitMEX and Binance both use 8-hour intervals). At a high level, a funding rate is computed by assessing the average difference between a perpetual swap’s price and its underlying’s price during a specific interval of time. The amount you are entitled to pay or receive as a result is based on what this funding rate is, and the direction and size of your position. Specific implementation details vary from exchange to exchange and are explained in greater depth in a separate post, but generally, you will pay or receive: the funding_rate * position_notional depending on whether the funding rate is positive or negative, and whether you are long or short.

Cool, but show me an example!

Let’s do it! To give you a concrete example of how funding rates work, we’ll take a look at BitMEX’s approach and how funding rates impact a hypothetical trader Alice, who is holding a 5 BTC/USD long position.

BitMEX employs an 8-hour funding rate paid out periodically at 4 UTC, 12 UTC, and 20 UTC every day. The funding rate calculated during an 8-hour time frame is applied to the following interval. On June 7, 2020 between 4 UTC-12 UTC, the price of the BTC/USD perpetual swap was fairly consistently above the underlying spot price of Bitcoin. Consequently, the funding rate for the next time frame (12 UTC-20 UTC) was determined and set to be 0.01%. At the end of this interval (i.e. at 20 UTC) the funding rate payment will occur (keep in mind the BitMEX perpetual contract is inverse, so the payouts will be in BTC, not in USD):

funding_rate_payment = funding_rate * position_notional
funding_rate_payment = 0.0001 * 5 BTC
funding_rate_payment = 0.0005 BTC

It’s important to note that in this scenario, Alice (who is currently long) will be paying the 0.0005 BTC to short traders since the funding rate of 0.01% is positive, thus short positions need to be incentivized.

The bottom line

Perpetual swaps are far and away the most actively-traded product in the crypto space. These instruments fundamentally stay in line by balancing supply and demand via a funding rate mechanism. If the price of the perpetual swap is close to spot price it’s tracking, the funding rate transfer is small to bring it back into line. The farther off it gets, the higher these payments will be. Funding rate fees are a function of the notional position size (regardless of leverage), so can have a significant impact on traders, especially those who are highly-leveraged. Funding rate fees or rebates can materially affect the profit & loss (PNL) profile of a position, so it’s important to understand them fully!

To get an idea of how just how important funding rate fees and rebates are your PNL, here’s an example of how a positive funding rate can impact long BTC/USD traders with varying degrees of leverage:

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How do funding rates vary from one exchange to another?

As shown in this chart, funding rates can vary quite a bit between exchanges.

• Funding rate calculation: each exchange employs a different methodology for calculating funding rates. The exact methodologies will be covered in great detail in a related post, but the key idea is that the funding rate needs to measure the spread between the perpetual swap’s price and that of the underlying. Although unintuitive, it turns out exchanges measure these prices differently. For example, BitMEX takes order book depth (i.e., how much is being bought or sold through several price levels of the order book) into account, whereas FTX simply takes the average of the last traded price, highest bid (buy) price, and lowest ask (sell) price.
• Funding fee transfer mechanics: How often an exchange calculates the funding rate and transfers the fee can also vary! For example, BitMEX computes the funding rate every 8 hours, setting the funding rate for and paying out at the end of the next interval (i.e., the funding rate computed based on the markets between 4 UTC-12 UTC set the funding rate between 12 UTC-20 UTC; the funding fee will be paid out at 20 UTC). Deribit, however, computes the funding rate every millisecond and will conduct funding rate fee transfers as a result at this high, essentially “continuous,” frequency.

What is the funding rate basis trade?

Funding rates can increase or decrease the PNL profile of long or short perpetual swap trading strategies. It’s possible, however, to employ a trading strategy whose PNL is solely based on the funding rate and will not gain or lose value as a result of the underlying asset moving in price.

The idea is to take a long or short position on the perpetual swap market and take an offsetting position on the underlying spot market. This will make your position fairly insensitive to price fluctuations on the underlying, but will allow you to collect (or in the downside scenario, pay) the funding rate fee.

As mentioned earlier, funding rates tend to be positive (long traders pay short traders), so let’s take the scenario where a trader, Alice, would like to remain market neutral with respect to Bitcoin’s price, but wants to collect the funding rate fee. Alice can take the following steps:

• purchase 1 Bitcoin on a spot exchange on May 14, 2020 (0:00 UTC) at $9301.5
• sell 1 BTCUSDT perpetual swap contract on Bybit at approximately the same price and time

Her trade’s PNL would have looked like this during the month of May 14, 2020 to June 15, 2020:

Any profit or loss Alice would get from Bitcoin rising or falling in price due to her long spot position would be roughly offset by her short perpetual swap position. However, she is betting on a positive funding rate (long perpetual swap position holders paying short position holders, like herself). In this month, she profited over $90. Annualizing this period’s return implies an 11% ROI — not bad!

Additionally, it’s worth noting that the funding rate pays traders who have the basis trade on in the right way. For example, let’s take another scenario where the BTC/USD perpetual swap is trading substantially lower than the spot price of Bitcoin. A basis trader, Alice, might bet that these prices will converge by buying the perpetual swap and selling the spot asset. If/when these two instruments converge, Alice can close her position profitably, while also collecting the negative funding rate-related fees, further increasing her profits.

Did you know funding rates can indicate how much people are willing to pay for leverage?

One of the advantages of perpetual swaps is the high leverage they allow traders to take when entering positions. For example, traders wishing to bet on Bitcoin rising in price can purchase Bitcoin on a spot exchange with some capital. An exchange offering perpetual swaps, such as BitMEX, lets these same traders get up to 100x the Bitcoin upside exposure with this same amount of capital. The amount that the perpetual swap is trading above the spot price of Bitcoin comes with a funding fee cost that these long traders have to pay. You can think of this as the cost traders are willing to pay in order to lever up their trades via buying perpetual swaps.

Thanks to Ainsley Sutherland for her review!
Thanks to Cody White (CMS), Jason Lu (Grapefruit), and Haseeb Qureshi (Dragonfly), and Sherwin Dowlat (Polychain) for their review!