https://medium.com/derivadex/what-is-the-funding-rate-for-perpetual-swaps-a0335c4228a9
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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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 ispositiveif perpetual_swap_price < underlying_price => funding_rate isnegative
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.
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.
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!