What is a Contract?

Before understanding the term “funding rate,” let’s introduce a basic concept: “contract.”

A contract is an agreement in the futures or derivatives market where traders buy or sell an asset at a predetermined price and time. The main types of contracts on current cryptocurrency trading platforms are delivery contracts and perpetual contracts.

A delivery contract is an agreement to buy or sell the underlying asset at an agreed price on a future delivery date (weekly, bi-weekly, or quarterly). Perpetual contracts, on the other hand, are unique to the cryptocurrency industry. The biggest difference is that perpetual contracts have no expiration or settlement date, meaning investors can hold positions indefinitely unless they are forcibly liquidated. Compared to traditional futures, perpetual contracts also offer higher leverage.

Perpetual contracts are further divided into USDT-margined contracts and coin-margined contracts, depending on the type of margin and settlement currency.

What is the Funding Rate?

Since perpetual contracts do not have a set settlement date, trading platforms need to establish a mechanism to anchor the spot price. This mechanism is known as the funding rate, and it ensures that the contract trading price remains in sync with the index price (which is the average price of the latest spot prices across multiple exchanges) and avoids prolonged price deviations.

The funding rate is exchanged between long and short position holders, typically settling every 8 hours. If the funding rate is positive at the time of settlement, long position holders pay a fee to short position holders; if it is negative, they pay a fee to long position holders. Gate.io does not charge any fees.

Different platforms may have slightly different rules for the funding rate. On Gate.io, the funding rate is calculated every minute, and the average of one cycle (8 hours) is used as the final funding rate, which is applied during each funding rate cycle (8 hours). The settlement times are usually at 0:00, 8:00, and 16:00 UTC.

Note: Not all trading pairs have an 8-hour funding rate settlement cycle; some have a 4-hour cycle. The funding rate settlement cycle can be checked on the contract information page.

（Source: Gate.io，2024.08.12）

As shown in the above figure, the funding rate for the BTC_USDT perpetual contract is currently 0.0035%, with 2 hours and 41 minutes remaining until the next settlement time.

What are the Factors that Influence the Funding Rate?

The funding rate primarily depends on two major factors: interest rates and premiums. The specific calculation methods for the funding rate may vary across different trading platforms.

Interest rates are usually set as a fixed value by the platform. For example, on Gate.io, the preset interest rate for contracts is 0.03% per day. If the fee settlement occurs every 8 hours, the interest rate difference would be 0.01%, and so on.

https://www.gate.io/zh/futures_info_new/futures/usdt/BTC_USDT#baseinfo

The specific calculation formula is as follows:

Funding Rate = Premium Index + clamp (Interest Rate Difference - Premium Index, 0.05%, -0.05%)

Here, “clamp” is a range-limiting function, and the final funding rate is: clamp (8-hour average, fmax, -fmax), where fmax = (Initial Margin - Maintenance Margin) × 75%.

Premium Index = [Max (0, Depth-weighted Buy Price - Index Price) - Max (0, Index Price - Depth-weighted Sell Price)] / Index Price

For more details on the Premium Index, please refer to the contract information page.

In the fmax formula, the parameter 75% is the default value. In extreme market conditions, Gate.io reserves the right to adjust the upper and lower limits of the funding rate, with prior notice to users.

The upper and lower limits of the funding rate for cryptocurrencies also vary across platforms. Gate.io users can check the perpetual contract information page for details.

Source: Gate.io

The Correlation Between Changes in Funding Rates and the Market

Historical data shows that the funding rate plays a role in balancing long and short forces in cryptocurrency perpetual contract trading. It is closely related to market conditions, with market fluctuations impacting the funding rate, and changes in the funding rate also affecting market prices and trader behavior to some extent.

When market prices consistently rise, the demand for long positions increases, leading to a positive and rising funding rate. In this situation, long position holders must pay fees to short position holders, and as the funding rate increases, the fees also rise.

An increase in the funding rate means higher costs for long positions, which may lead to long positions being closed or short positions being liquidated, thus impacting market prices. For example, a high positive funding rate might cause long positions to close, potentially suppressing the price increase.

When market prices consistently fall, the demand for short positions increases, which may result in a negative and declining funding rate. In this case, short position holders need to pay fees to long position holders, and as the funding rate decreases, the cost of holding short positions also increases.

A high negative funding rate could lead to short positions being closed. In extreme market conditions, this could result in a “short squeeze,” where a surge of short position liquidation orders floods the market, leading to a sharp increase in buying pressure and causing the asset price to rise rapidly within a very short period.

When the funding rate remains at a low level, the cost of holding positions decreases, which might attract more long or short positions into the market, thereby causing market fluctuations.

For example, in the following graph,

Source: Coinglass

When BTC prices significantly increase or decrease over a period of time, the funding rate generally aligns with the price trend in the broader direction.

For example, from February 26, 2024, to February 29, 2024, BTC’s price surged from around $51,000 to about $63,000, an increase of over 23%. During this period, the funding rate also rose sharply from around 0.01% to a peak of 0.08% based on trading data from major platforms. Conversely, from April 1, 2024, to April 3, 2024, BTC’s price fell from around $71,500 to $65,000, and the funding rate dropped from a high of 0.07% to approximately 0.015%.

However, it should be noted that the relative tops or bottoms of BTC prices and funding rates are not always perfectly synchronized. For instance, a short-term peak in BTC prices does not necessarily mean that the funding rate has also peaked at that moment, and a short-term bottom in BTC prices does not guarantee that the funding rate has reached its lowest value for that period.

For example, in the early morning of May 2, 2024, BTC’s price was around $57,000, a relative bottom since April 24, 2024. At that time, the funding rate across major platforms was around 0.01%. However, although BTC’s price rose to $63,000 in the following two days, the funding rate did not show a positive correlation. Instead, it dropped to a negative value on May 3 before eventually returning to positive.

Source: Coinglass

Source: Coinglass

Additionally, compared to mainstream cryptocurrencies like BTC and ETH, altcoins such as DOGE and WIF exhibit more pronounced fluctuations in their funding rates due to their significant price volatility. In extreme market conditions, the funding rates for these altcoins can even reach as high as 0.2% to 0.3%.

Source: Ethena

However, Ethena data shows that over the past 3 years, BTC’s funding rate has been predominantly positive, with negative rates occurring only in a few instances (typically during bear markets). To some extent, the long-term positive trend in the funding rate reflects a general optimism among traders towards the cryptocurrency market.

The Impact of Funding Rates on Traders

For perpetual contract traders, the funding rate is a crucial factor that affects holding costs, trading profits and losses, and trading strategies.

As mentioned earlier, the funding rate directly impacts the trader’s holding costs and unrealized profits and losses. A higher positive funding rate increases the holding cost for long positions. Conversely, a negative funding rate increases the holding cost for short positions. Regardless of whether the funding rate is positive or negative, a high funding rate can lead to increased market volatility. Even with low leverage, traders may still incur losses or face the risk of forced liquidation.

Therefore, traders need to closely monitor changes in the funding rate and consider it as one of the indicators of market sentiment to adjust their trading strategies flexibly. For example, when the positive funding rate is excessively high, it usually indicates overly optimistic speculative behavior among participants, so traders might consider reducing positions or closing them early. Conversely, when the negative funding rate persists for a period, it often reflects prolonged market weakness and widespread pessimism among traders, which can be an indicator of a market bottom.

Professional traders might also exploit differences in funding rates across platforms for arbitrage opportunities. For instance, they could go long on a platform with a lower funding rate and short on a platform with a higher funding rate, thus profiting from the discrepancy.

Conclusion

The funding rate is a crucial factor in cryptocurrency perpetual contract trading, determined by market forces. Market movements, whether up or down, affect the funding rate’s fluctuations. At the same time, the funding rate also influences market structure to some extent, driving changes in long and short forces in the market. For traders, it is important to adjust their position strategies promptly based on changes in the funding rate to optimize costs and reduce risks, thereby maximizing returns.