Funding rate plays a crucial role in the cryptocurrency derivatives market, particularly in perpetual futures contracts.
These rates are vital to maintaining the stability of the market and ensuring that the price of perpetual contracts stays close to the spot price of the underlying asset.
In this article, we demystify funding rate, how it works and why it is important for crypto traders to understand it.
The concept of funding rate
The funding rate in crypto trading is a mechanism used primarily in perpetual futures contracts to maintain the price of the contract close to the underlying asset’s spot price.
In simple terms, a funding rate is a periodic payment exchanged between traders who are long (buyers) and those who are short (sellers) on a perpetual futures contract.
Unlike traditional futures contracts that have an expiration date, perpetual contracts do not expire. This makes it necessary to have a mechanism to ensure that the contract price remains close to the spot price of the underlying asset. Funding rates serve this purpose.
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How funding rate works
Funding rates are calculated every 8 hours, although this can vary depending on the exchange. The rate is based on two primary factors — interest rate differential and premium index.
The interest rate differential is the difference in interest rates between the asset being traded and the stablecoin (often USDT) used as collateral.
Meanwhile, the premium index measures the difference between the perpetual contract price and the spot price of the underlying asset.
Funding rate can be either positive or negative. When the perpetual contract price is higher than the spot price, the funding rate is positive. In this case, traders holding long positions pay a fee to those holding short positions. The goal is to incentivize long traders to reduce their positions, which brings the contract price closer to the spot price.
On the other hand, funding rates often read negative when the perpetual contract price is lower than the spot price. Here, shorts pay longs, encouraging more buying and pushing the contract price up towards the spot price.
Notably, funding rate is expressed as a percentage of the position size and is automatically deducted from the traders’ accounts.
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The role of funding rates in the crypto market
The primary function of funding rates is to keep the price of perpetual contracts aligned with the spot price of the underlying asset. Without this mechanism, perpetual contracts could drift significantly from the spot price, leading to market inefficiencies. Therefore, funding rates help to ensure balance in the crypto market.
Funding rates can also be an indicator of cryptocurrency market trends or cycles. A consistently high positive funding rate suggests bullish sentiment, as more traders are willing to pay to hold long positions. Conversely, a negative funding rate indicates bearish sentiment, with more traders opting to short the asset.
In addition, funding rates can affect a trader’s profitability. In essence, crypto traders should consider it when holding positions for extended periods, as it can affect profitability. For example, a high positive funding rate can erode profits for long traders if they hold the position for a long time.
Imagine you are trading a perpetual futures contract for bitcoin (BTC). If the funding rate is 0.01% and you hold a $10,000 long position, you would pay $1 to the short position holders at the funding interval if the rate remains positive. If the rate is negative, you would receive $1 from the short traders.
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Final thoughts
While funding rates are a critical aspect of perpetual futures trading, they also introduce certain risks, including high funding costs and market manipulation.
In volatile markets, funding rates can become quite high, making it expensive to maintain a position. This can lead to forced liquidations if traders are not careful. Likewise, some traders may attempt to manipulate the funding rate by opening large positions to push the rate in a favorable direction.
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