Funding Rate Arbitrage

Risk Free Futures Trading Strategy Episode 2 of 2

(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)

This article follows our previous episode of the Risk Free Futures Trading Strategy series where we introduced the basics of futures contracts and how to perform a cash and carry arbitrage trade to capture basis. We now move on to a more complex topic and introduce perpetual futures contracts and the funding rate arbitrage.

As for the crypto dated futures contracts, perpetual futures were introduced by BitMex and are now widely available across crypto exchanges. Perpetuals are extremely popular amongst crypto traders who can engage in leverage trading without having to worry about the technical specificities of a traditional dated futures contact.

At time of writing, the total open interest of perpetual contracts on Bitcoin across all crypto exchanges was $23B while OI on deliverable contracts stood at $15B.

Perpetuals 101

A perpetual contract is an innovative derivative product introduced by BitMex in 2016. The main difference with traditional dated futures contracts is that perpetuals do not expire and thus allow traders to hold their position indefinitely. Unlike dated futures which trade in contango most of the time due to basis, perpetuals trade closer to their underlying indexes thanks to the funding rate mechanism.

The funding rate is the key point to understand for our arbitrage set up as it is what we will attempt to capture. The funding rate is the interest rate exchanged in the form of cash payments between longs and shorts. It is typically payed, or received, every 8 hours (BitMex and Binance) or 1 hour (FTX and MangoMarkets).

There is a common misconception in the funding rate understanding. Funding rate DOES NOT represent the amount of longs vs shorts. It is simply the premium or discount between the perp and the spot price. The mechanism ensures that the price of the derivative is roughly tethered to its index.

The premium or discount can however be used as a metric for market sentiment. For example if the funding rate is +0.001% per hour, longs expect the price to move by over 0.001% per hour and vice versa for shorts if funding is negative. That being said it could be used as an indicator for overheating directional bets. An unsustainable level of funding rate can make a trade too expensive to hold as price does not move fast enough to cover the funding and thus force a trader to close the position.

We now understand what arbitrage is and the concepts of delta-neutral exposure from our previous episode, and what funding rate is. Let’s dive into funding rate arbitrage.

Funding rate arbitrage

For funding rate arbitrage we are solely interested in capturing the funding rate distributed over a pre-determined time frequency and have no interest in the direction the asset is taking. Since our trade is set up to be hedged on both sides our position is delta neutral, and we are thus not exposed to price fluctuation.

Looking at the below chart of the historic annualized Bitcoin funding rate on Binance, we can see that it is positive most of the time, meaning longs are paying shorts to bet on upside price direction. So shorts are getting paid.

Funding rate on Binance is paid every 8 hours. In this case short traders would receive the funding rate most of the time. However being short alone exposes traders to a negative impact on their PnL if the price of Bitcoin rises as it is a directional bet.

We need to set up the trade so we are delta neutral and thus not exposed to any price fluctuation.

The Trade

Because funding rate is positive most of the time, longs pay shorts so we obviously want to short the Bitcoin perpetual contract. Meanwhile, we also want to protect this short position so we are not exposed to price moves and a loss should BTC go up. We want to hold the same amount we’re short of as collateral to hedge the position.

The set up would theoretically look like this: Buy spot Bitcoin, and immediately short the same amount of Bitcoin through the perpetual contract while using our spot BTC as collateral. We ideally want to buy spot and short perp BTC at the same price to totally ‘cancel out’ the position.

Let’s look at the scenarios with a price of Bitcoin bought spot and shorted at $40,000.

Scenario 1: Bitcoin goes to $60,000

The spot Bitcoin PnL is +$20,000. It is hedged by the short position with a PnL of -$20,000. Our exposure is none so we are not affected by price direction.

Scenario 2: Bitcoin goes to $20,000

The spot Bitcoin PnL is -$20,000. It is hedged by the short position with a PnL of +$20,000. Again were are not exposed to price fluctuation.

These scenarios simply portray that the price movement does not matter. Our PnL on the positions will always be 0.

However, while we did not make any directional bet and our PnL is 0, we did collect funding rate every 8 hours during the time of the trade.

Looking at the 7 day average on Binance we have a funding rate of +0.0062%, which gives us 7.44% annualized.

So performing this trade over the last 30 days would have secured us an annualized return of 7.44% without taking any risk. Note that although 7.44% APR doesn’t sound exciting in crypto world we can catch double digit yields in times of market euphoria.

Looking at funding rate history when Bitcoin was trading above $60K we can see that the funding rate was trending around 0.04%, giving us over 40% APR.

DeFi boosted yields

We can also explore boosted yields on DeFi applications like dYdX and MangoMarkets, where there are less arbitrageurs and thus competition to trim down the premiums and discounts.

Here is the 7 days funding rate history on MangoMarkets. We can see that longs were getting paid most of the time for a double digit APR.

In this case the trade’s set up would be reversed from the example performed on Binance above, as we have to long the perp contract, and short the spot to be completely hedged.

Let’s continue with BTC for the example:

We have to go long perp BTC to receive the funding rate so we have to be short BTC spot. So first we borrow 0.03 BTC which would look like this on the book:

This position alone is directional as we make money if the price of BTC drops and can lose and get liquidated if the price rises.

Longing the exact same amount of BTC through the perp will neutralize that:

Here the PnL doesn’t matter as we executed the borrowing and the long at the same prices, or about the same to a few $ difference.

So what I lose on the long I make on the borrow:

Long 0.03 perp BTC: Current price of $39,769.91 — Entry price of $39,781.20 = -$11.29
Borrow 0.03 BTC: Entry price of $39,781.20 — Current price of $39,769.91 = +$11.29

Meanwhile the funding rate is paid out every hour on MangoMarkets with a current rate of -0.0039% (34% APR).

The payment is distributed every hour. I let it run over one weekend, here is what it looks like:

The funding rate will fluctuate over time as the market gets more or less volatile. And although we picked Bitcoin for our example, some assets are more profitable to do perform this strategy on.

As for all arbitrage strategies, the more funds you do it with the higher the potential profits. I ran the example with $966 but it gets much more interesting with a larger cash balance.