Hello Traders! We last talked about different types of futures and how they differ. Perpetuals emerged as a key tool in a crypto trader’s arsenal but we did not dive too deep into how they are structured. Namely, perps require a “funding rate” to keep prices in check. Today we’ll dive into what that is, how it works, and what it looks like in practice.
What are Funding Rates?
A funding rate is a premium paid by one of the counter-parties in a perpetual futures trade to correct the future’s price to the spot price. Given the leverage and speculative nature of perps, it is not uncommon for them to exceed the spot price during bull runs and fall below it during downturns. While market makers arbitrage the spread to help correct this, the perp also uses a funding rate to help accelerate this price matching.
How Are They Set?
Funding rates are typically quoted and adjusted in eight-hour intervals. They may be paid out hourly or on another time frame but the rate typically lasts eight hours. During this time, if the rate is positive, longs will pay shorts a premium and if it is negative shorts will pay longs. Remember:
Positive funding rate: longs pay shorts
Negative funding rate: shorts pay longs
This makes sense intuitively as owning an asset at a premium or a discount should come with some cost. The more the perp extends beyond the spot price, the higher the funding rate will be.
Funding In Action
If you look at the BTC funding rate over time (bar chart below), you can see it peak during the most recent bull cycle and halving. This was a wildly speculative time and many people used highly levered perpetuals to ride this wave up. This pushed the perp price well above the spot price and required high funding rates to correct it.
Funding rates can thus be used as a sort of leading indicator or index of the market’s sentiment. When they are high, traders have strong conviction about future performance. While they are low, the market is fearful.
Trading Funding Rates
The above chart also shows funding rates across exchanges. These different markets have different volumes and a large buy or sell can push the rate to greatly differ from other exchanges.
You can track these rates in real-time here:
This spread also creates a trading opportunity! We’ll dive into this in a future strategies piece.
