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What are funding rates in cryptocurrency?
Differences between perpetual and traditional futures
The first futures appeared in ancient Japan: rice sellers would agree in advance with buyers on the quantity of rice to be delivered on a certain date and at a set price. This arrangement benefited both parties:
- Sellers were assured their rice would be purchased at an agreed-upon price. While the price could rise, it could also fall.
- Buyers were guaranteed their rice supply and didn’t worry about it selling out.
Over time, futures became one of the derivative financial instruments in markets. Today, we have two types of futures: traditional and perpetual. Traditional futures are no different from those used in ancient Japan: they specify the quantity of the asset to be delivered, its price, and the expiration date (when the asset will be delivered and paid for).
Perpetual futures were created specifically for crypto trading by the BitMEX exchange in 2016. Essentially, a perpetual future is similar to a contract for difference (CFD), which first appeared in London in the early 1990s.
The main difference between traditional and perpetual futures is that a trader can hold the latter without an expiration date. When you buy a perpetual future, you automatically use leverage (even if it’s x1) and can hold the position as long as you have enough margin (funds on the exchange deposit).
Settlement for perpetual futures doesn’t occur in the traditional sense, so a mechanism is used to regularly align futures prices with the index (the average asset price across multiple spot markets) – this is called the funding rate or funding.
What is funding?
Funding rates represent regular payments that traders with long or short positions either receive or pay based on the difference between spot market prices and perpetual futures market prices. A trader either receives or pays funding depending on the direction of their position.
The function of funding is to eliminate prolonged price discrepancies between these markets.
Funding rate formation
The funding rate consists of two components: the interest rate and the premium.
The interest rate is fixed at a certain level, usually 0.03% per day. The premium, however, varies depending on the price gap between the perpetual contract and the spot price.
During high market volatility, the perpetual contract price may deviate from the mark price. In these situations, the premium can increase or decrease.
A large spread between prices increases the premium. Conversely, a small premium indicates minimal price divergence.
If the funding rate is positive, it means the perpetual contract price is above the mark price, and long traders pay shorts. When the funding rate is negative, short positions pay long positions.
The funding rate payments occur directly between traders, with no fees or exchange involvement.
How to profit from the funding rate
It may be surprising to some, but you can also make money on funding arbitrage, just like on spot and futures markets. To do this, you need to find two exchanges with different funding rates (one positive and one negative) for the futures of the same coin. There are two main requirements for this strategy to be profitable:
- One of the funding rates must be due soon.
- Only open trades when the long future is cheaper than the short. If the prices are equal or the long is more expensive than the short, you might break even or make only a small profit. Here’s an example of when not to open positions:
The profit will be minimal, and that's only if the price movement aligns with your strategy. Otherwise, you may incur losses.
Next, follow these steps:
- Open a long position on the exchange where the funding rate will be paid out soon.
- Open a short position on the exchange where the funding will be applied later.
- After the funding is credited to the long position, close both trades.
In the end, you gain profit from the funding payout, as well as from one of the futures contracts, depending on the price movement, capturing the price difference.
Example of earning from funding arbitrage
In this case, an ArbitrageScanner user noticed a difference in the funding rate for the BOND token on two exchanges—Gate and MEXC. On MEXC, the funding rate was scheduled to be credited in 7 minutes.
On Gate, it was scheduled for 4 hours later. This formed the basis for the arbitrage opportunity.
The user opened a long position on MEXC and a short position on Gate with an equal amount of tokens, timing it so that the funding rate on MEXC was negative, meaning that shorts were paying longs. This way, he received the funding rate payout on MEXC as a long holder and exited the position before he would have had to pay for the short on Gate.
He went long on 750 BOND tokens at a price of $1.281 on MEXC and simultaneously opened a short for the same amount of tokens on Gate. The funding rate credit for the long position on MEXC amounted to $19.15.
Afterward, he closed both positions in stages by placing partial orders, also earning on the price spread. The lack of maker fees on MEXC futures further reduced costs and increased profit.
The short on Gate resulted in a loss of $164.46, while the long on MEXC yielded a profit of nearly $191. In total, the arbitrage profit was $26.54 (191 - 164.46).
Conclusion
In closing, it’s worth noting that funding is a key tool for crypto arbitragers. Using its mechanism correctly not only allows for better control of positions but also generates additional profit through arbitrage. Funding arbitrage can be profitable even in a stable market, and ArbitrageScanner assists in this by providing timely information to support sound decision-making.
