What is the Funding Rate

Principles of Funding Rates

1. Operational logic of the funding rate mechanism: Perpetual contracts are a special kind of futures contract, which, unlike traditional futures, have no expiration date or settlement date. When the spread between the price of the perpetual contract and the spot price goes beyond a reasonable range, the funding rate mechanism will function to pull the spread back to a reasonable level.

2. Generally speaking, the larger the spread is, the better the funding rate mechanism works. The mechanism works to “adjust” the perpetual contract price to get it close to the spot price and to the maximum extent.

3. The funding rate is an important mechanism which anchors perpetual contracts’ prices to the spot prices, and it is used to balance long and short sentiment. When the funding rate is > 0, the longs pay the shorts; when the funding rate is <0, the shorts pay the longs. Funding fee paid or obtained = nominal value of the position * funding rate.

4. Funding is only circulated between long and short users, while the platform does not participate in the allocation of any funding. Generally, it is charged once every 8 hours, 3 times a day. The Gate.io contracts are settled at 0:00, 8:00, and 16:00 UTC every day. There is no need to pay or receive funding if positions are closed before the settlement time.

Development history of funding rate

The history of the funding rate mechanism can be traced back to May 2016, when BitMEX took the lead in launching BTC-based perpetual contracts. BitMEX invented the funding rate mechanism in order to ensure that the contract’s price is anchored to the spot index price, that is, to transfer funds between long and short traders once a day to balance the supply and demand between long and short sides in the market. Since June 5 of the same year, the frequency of fund exchange has been changed to three times a day (GMT+8 time 4:00, 12:00, 20:00), and the frequency has been adopted by most crypto-asset derivatives exchanges today.

Application of Funding Rate

At present, the encryption market generally believes that there are two usages of funding rates:

It can be used to judge the long and short sentiment of the market:

According to the principle of funding rate, when the market works in favor of one side to cause a significant imbalance between the long and short sides, the funding rate mechanism will play a role in making the dominant side pay. We believe that the funding rate adheres to the following rule to play in the market:

1. The funding rate is positively correlated with the price trend;
2. The funding rate has latency in predicting market trends;
3. The funding rate is of certain reference significance for judging market conditions.

Achieve risk-free arbitrage between spot and contract by using the funding rate

1. Arbitrage process:

   1. If the funding rate＞0, buy the spot and open short for contracts of the same value. When the funding rate approaches 0, investors complete the arbitrage by closing the short positions for contracts and closing the spot positions.
   2. When the funding rate＜0, open long positions for perpetual contracts, and at the same time, sell short in the leveraged trading by borrowing currency. When the funding rate approaches 0, investors complete the arbitrage by closing the long positions for perpetual contracts, closing the short positions for leveraged trading, and repaying the borrowed currency.
      Automatic arbitrage on the Gate.io quantitative trading platform:
      

2. Precautions for funding rate arbitrage:

   1. When the funding rate > 0, positive arbitrage income = capital cost income - (spot + contract position opening/closing fee)
   2. When the funding rate is＜0, reverse arbitrage income = capital cost income - (leverage loan interest + margin transaction fee + contract position opening/closing fee)
   3. There is a risk of liquidation.
      When the price fluctuates violently, both the contract and the leverage are at risk of being liquidated. After being liquidated, the imbalance of positions will inevitably lead to losses. Therefore, it is recommended that the leverage of the contract should not exceed 3 times. Spot leverage is also subject to the risk of liquidation, and we should pay special attention to low leverage.
   4. Please note that the arbitrage income may not cover the handling fee when the funding rate fluctuates frequently.

Conclusion

The perpetual contract funding rate is a fundamental yet important concept in contract products, which is used to reflect the market sentiment and capital strength in the short term. We can use it to achieve risk-free funding rate arbitrage. For more information on funding rates and arbitrage operations, please visit the Gate.io contract platform and click to register.

Disclaimer
This article is for informational purposes only, and any contents provided herein do not constitute investment advice, nor is Gate.io responsible for any of your investments. Contents such as technical analysis, market judgment, trading skills, and trader sharing may be subject to potential risks, investment variables, and uncertainties. This article does not suggest or imply any opportunities with guaranteed returns.