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Abstract

This article explores the evolution and significance of the funding rate in cryptocurrency derivatives markets, with an emphasis on its origins, mechanisms, and the arbitrage strategies it inspires. It highlights the “Golden Age” of funding rate arbitrage in Spring 2021, the subsequent decline due to market corrections, and the rebirth of these opportunities in 2024-2025 with the advent of innovative stablecoins like USDe and USDX. The critical role of CME in influencing funding rates is discussed, showing how traditional finance (TradFi) intersects with decentralized finance (DeFi). Finally, the paper argues that the influence of institutional players and CME, rather than emerging stablecoins, shapes funding rate dynamics, urging a reconsideration of the ecosystem’s narrative.

The funding rate originates from the cryptocurrency derivatives market, particularly from perpetual futures contracts. It serves as a mechanism to maintain the price of the perpetual futures contract close to the underlying asset’s spot price. The concept was developed to address issues inherent in traditional futures contracts, such as their expiration and settlement, which can create discrepancies between futures and spot prices.

Key Context of the Funding Rate:

Introduced by Cryptocurrency Exchanges:

The funding rate became widely recognized and used with the rise of cryptocurrency exchanges like @BitMEX founded by @CryptoHayes in 2016. BitMEX popularized perpetual futures contracts, a type of derivative that does not have an expiration date, allowing traders to hold positions indefinitely.

To ensure the contract price remains close to the spot price, the funding rate was implemented.

Mechanism:

The funding rate is a periodic payment (or receipt) between traders who are long (buyers) and short (sellers) in the market.

It is determined by the difference between the perpetual futures contract price and the spot price of the underlying asset.

If the perpetual price is higher than the spot price (indicating a bullish market), longs pay shorts. If it is lower (bearish market), shorts pay longs.

Purpose:

The funding rate incentivizes traders to take positions that help align the perpetual futures price with the spot price.

This reduces the potential for large discrepancies and keeps the market more efficient.

Calculation:

The funding rate is calculated based on two main components: the interest rate (often negligible) and the premium index (the difference between the futures price and spot price). The exact formula can vary between exchanges.

Evolution:

The funding rate has become a standard feature across major cryptocurrency exchanges, including @binance, @okx, @Bybit_Official, @DeribitExchange, and others.

It has influenced traditional finance derivatives by introducing innovative ways to manage price tracking and trader behavior.

The funding rate thus plays a vital role in ensuring the stability and efficiency of cryptocurrency perpetual futures markets, aligning them closely with the underlying spot markets.

What is Funding Rate Arbitrage?

Funding rate arbitrage is a trading strategy where traders exploit differences between the funding rates of perpetual futures contracts and the spot price of the underlying asset. The goal is to profit from the periodic funding payments made between long and short positions.

Key elements:

Long spot + short perpetual futures:

The trader buys the cryptocurrency on the spot market (e.g., Bitcoin) and simultaneously takes a short position in a perpetual futures contract of the same cryptocurrency.

1. This creates a hedged position where the trader is not exposed to price movements of the asset.

Profit from high funding rates:

1. When funding rates are high (a bullish market), traders with short positions receive funding payments from traders with long positions.

Spring 2021 - The Golden Age

The Spring of 2021 is often referred to as a “Golden Age of Funding Rate Arbitrage” in cryptocurrency markets because of exceptionally high funding rates during that period. This created lucrative opportunities for traders employing arbitrage strategies. Here’s an explanation of why this period stood out and how funding rate arbitrage worked during that time:

1. Explosive Market Growth

The cryptocurrency market witnessed unprecedented growth during early 2021, fueled by:

Institutional adoption of Bitcoin and other cryptocurrencies (e.g., Tesla, MicroStrategy).

DeFi boom and growing retail participation.

• Bullish sentiment that pushed Bitcoin and Ethereum to new all-time highs.
• This resulted in a sustained premium on perpetual futures contracts as bullish traders dominated the market.

1. 1. Exceptionally High Funding Rates

• Funding rates soared to record highs as long positions significantly outnumbered short positions.

For example:

Bitcoin perpetual funding rates on exchanges like Binance and Bybit frequently exceeded 0.1% to 0.3% per 8-hour period.

• On an annualized basis, this equated to 36%–108% returns, far exceeding traditional fixed-income investments.

1. 1. Arbitrage-Friendly Market Conditions

• Market inefficiencies: Large premiums in perpetual futures prices created consistent funding payments.
• High liquidity: Major exchanges had abundant liquidity, enabling traders to execute arbitrage strategies efficiently.
• Low counterparty risk: The introduction of insured custody solutions and exchange-provided wallets reduced the risks associated with holding large amounts of cryptocurrency for arbitrage.

How Traders Capitalized on the Opportunity

Hedging with Spot or Traditional Futures:

1. Traders hedged long positions on the spot market with short perpetual futures contracts to collect funding payments without price risk.

Institutional Players Entering Arbitrage:

1. Hedge funds, proprietary trading firms, and sophisticated individual investors aggressively entered the funding rate arbitrage space, deploying large capital to lock in consistent profits.

Annualized Returns:

1. With annualized yields exceeding 100% in some cases, funding rate arbitrage became one of the most attractive risk-neutral strategies in the crypto market.

Decline After the Boom

By mid-2021, funding rates normalized as:

• Market corrections occurred after Bitcoin hit $64,000 in April 2021, followed by a sharp downturn in May.
• Increased competition in arbitrage reduced profitability.
• The rise of more efficient market participants (e.g., automated market makers, quant funds) began to stabilize funding rates.

Legacy of Spring 2021: Expansion

The Spring 2021 Golden Age of Funding Rate Arbitrage left an indelible mark on the cryptocurrency ecosystem, illustrating both the potential and fragility of the market’s exponential growth. While the period highlighted the lucrative opportunities during bullish market conditions, it also laid the groundwork for significant systemic risks that would manifest in subsequent years.

Opportunities and Market Growth

Highlighting Funding Rate Dynamics

The high funding rates during this period emphasized the unique role of perpetual futures contracts in crypto markets as a tool for both speculation and price discovery.

1. Traders and fund managers capitalized on the arbitrage opportunities created by discrepancies between spot and perpetual prices, which were fueled by bullish sentiment.

Rise of Institutional Participation

The arbitrage-friendly conditions attracted institutional players and sophisticated fund managers who began deploying large sums of capital into crypto markets.

1. This influx of institutional interest boosted the legitimacy of cryptocurrency as an asset class while accelerating innovation in financial products.

USDT Circulating Supply Surge

One of the most notable outcomes of the period was the meteoric rise in the circulating supply of @Tether_to Tether (USDT), a key stablecoin in the cryptocurrency ecosystem.

1. Between early 2021 and mid-2021, USDT’s supply skyrocketed from $4 billion to over $60 billion, reflecting the massive inflow of fiat capital into crypto markets. This surge facilitated trading, arbitrage, and liquidity provision across exchanges.

Cascade of Events Post-2021

Despite the optimism of Spring 2021, its legacy also included vulnerabilities that culminated in a series of catastrophic events:

Funds Deployed into Anchor Protocol@anchor_protocol""> @anchor_protocol (Terra/Luna@terra_money""> @terra_money founded by Do Kwon@stablekwon""> @stablekwon)

As fund managers sought higher yields, a significant portion of the capital flowed into high-yield platforms like Anchor Protocol, a flagship DeFi project on the Terra blockchain.

Anchor attracted capital with unsustainably high APYs (up to 20%), supported by Terra’s UST algorithmic stablecoin system.

1. This created a precarious structure where new inflows of capital were necessary to sustain yields.

The May 2022 Crypto Market Crash

Terra’s collapse in May 2022 marked one of the largest financial implosions in crypto history.

1. When Anchor Protocol could no longer sustain its yields, the de-pegging of UST triggered a death spiral for LUNA, leading to the evaporation of over $50 billion in market value and wiping out a substantial portion of crypto’s money supply.

Impact on FTX @FTX_Official and Alameda founded by SBF @SBF_FTX

FTX/Alameda, prominent players in the crypto ecosystem, became significant victims of the Terra collapse.

Alameda’s exposure to Terra and its role as “exit liquidity” for Terra/Luna losses led to tens of billions in losses.

1. This set the stage for FTX’s collapse in November 2022, exposing a house of cards built on opaque trading practices and mismanaged funds.

Ripple Effects on Crypto Lenders

Terra’s implosion had far-reaching consequences for crypto lenders and hedge funds:

Three Arrows Capital (3AC) @threearrowzcap founded by Su Zhu @zhusu, Genesis@GenesisTrading""> @GenesisTrading founded by Barry @BarrySilbert, BlockFi @BlockFi founded by Zac Prince, Celsius @CelsiusNetwork founded by Alex Mashinsky, and Babel Finance founded by me @goXmoonman (Again, I need to emphasize that I retired from Babel Finance in Nov 2021 and returned to restructure the company after the crash and made the only successful restructured case for crashed crypto companies in 2022) were heavily exposed to Terra and the broader market downturn.

1. The insolvencies of these entities created a cascading effect, further eroding confidence in the market and draining liquidity.

Key Lessons from the Legacy

Stablecoin and Liquidity Risks

1. The rapid growth of stablecoins like USDT in 2021 underscored their critical role in providing liquidity. However, the overreliance on algorithmic stablecoins (e.g., UST) without proper risk management exposed systemic vulnerabilities.

Sustainability of DeFi Yields

1. Projects like Anchor demonstrated the dangers of unsustainable yield promises, especially when supported by circular economic models or insufficient reserves.

Interconnectedness of the Crypto Ecosystem

1. The 2022 crash revealed how deeply intertwined crypto firms had become, with failures in one segment (e.g., Terra/Luna) cascading through lending, trading, and investment platforms.

Importance of Risk Management

1. The events highlighted the necessity for improved risk management and transparency across crypto firms, including better regulation of stablecoins, lending practices, and centralized exchanges.

2021 Golden Age Refletion

The “Golden Age” of Spring 2021 not only symbolized the peak of speculative fervor and financial innovation in crypto markets but also sowed the seeds for a series of failures. The surge in capital inflows, exemplified by the dramatic rise in USDT supply, amplified market growth while also creating systemic risks that would later destabilize the ecosystem. These events underscore the need for sustainable growth, robust risk management, and greater oversight as the cryptocurrency industry matures.

2024-2025: The Renaissance of Funding Rate Arbitrage with USDe and USDX

The period of 2024-2025 marks a renaissance in funding rate arbitrage, fueled by the rise of innovative stablecoins such as USDe by Ethena @ethena_labs founded by Guy @leptokurtic_ and USDX by Stables Labs @usdx_money founded by me @goXmoonman. These new-generation stablecoins aim to address systemic weaknesses exposed by the collapses of algorithmic stablecoins (e.g., UST) and create new opportunities for traders and institutions in the funding rate arbitrage space.

Key Drivers of the Renaissance

1. Evolution of Stablecoins

USDe (Ethena):

USDe introduces a novel model, combining on-chain collateralization with sophisticated risk management tools to ensure stability.

• It is designed to offer the resilience of fiat-backed stablecoins (like USDT) while leveraging on-chain transparency and decentralized mechanisms.

USDX (Stables Labs):

USDX employs similar mechanism but its back is multiple coins strategy. The strategy’s risk adjusted return is higher comparing the USDe’s strategy and can escape from negative funding rate.

• Its dynamic stability mechanism mitigates risks of cascading failures, providing a reliable medium for arbitrage strategies.

These stablecoins aim to maintain consistent pegs to the U.S. dollar while offering competitive yields, making them ideal instruments for funding rate arbitrage.

1. Market Maturity and Efficiency

Improved Infrastructure:

Decentralized exchanges (DEXs) and derivatives protocols have advanced significantly, offering higher liquidity, lower slippage, and better transparency compared to earlier cycles.

• On-chain perpetual futures platforms, like dYdX and GMX, now compete with centralized platforms, driving growth in funding rate opportunities.

Regulatory Clarity:

• Post-2022 collapses, regulatory frameworks for stablecoins and derivatives markets have become clearer, restoring trust in the ecosystem and attracting institutional players back to arbitrage strategies.

1. High Funding Rate Cycles

• The renewed interest in cryptocurrency as an asset class has led to a resurgence in bullish sentiment, driving up funding rates on perpetual futures markets.
• The introduction of tokenized real-world assets (RWAs), including tokenized stocks, bonds, and commodities, has expanded perpetual futures markets beyond traditional crypto assets, creating arbitrage opportunities across multiple asset classes.

1. Institutional Participation

• Hedge funds, proprietary trading firms, and other institutional players have embraced funding rate arbitrage as a low-risk, high-yield strategy in the crypto derivatives market.
• The backing of sophisticated stablecoins like USDe and USDX ensures reliable liquidity and stability for arbitrage trades.

Mechanics of the New Arbitrage Renaissance

Classic Arbitrage: Long Spot, Short Perpetual

Traders leverage USDe and USDX to execute hedged positions:

Long Spot: Buy the underlying cryptocurrency (e.g., BTC or ETH).

Short Perpetual: Sell perpetual futures contracts for the same cryptocurrency.

1. High funding rates in perpetual markets during bullish cycles allow traders to profit from funding payments without exposure to price volatility.

Enhanced Yield with Stablecoin Integration

Yield Boosting:

USDe and USDX offer integrated staking or yield-earning mechanisms, enabling traders to earn additional interest on their stablecoin holdings while participating in arbitrage.

Capital Efficiency:

1. These stablecoins are optimized for DeFi protocols, allowing traders to maximize leverage while maintaining lower risk profiles.

Cross-Asset Arbitrage

1. Expanding beyond cryptocurrencies, traders now arbitrage between tokenized real-world assets and their traditional counterparts, utilizing stablecoins as a bridge for liquidity.

Economic Impact

1. Rebuilding Trust in Stablecoins

• The success of USDe and USDX highlights the crypto industry’s ability to learn from past failures and design resilient financial instruments.
• This renewed trust in stablecoins attracts significant fiat inflows, boosting the overall liquidity of the crypto market.

1. Expansion of Arbitrage Opportunities

• The rise of diverse derivatives markets, including RWAs, has exponentially increased funding rate arbitrage opportunities.
• Arbitrage strategies now contribute to price stability across a wider range of assets.

1. Institutionalization of Crypto Arbitrage

• Funding rate arbitrage becomes a core strategy for hedge funds and asset managers, bridging traditional finance and crypto markets.
• The entry of institutional capital accelerates the growth and professionalization of the crypto derivatives ecosystem.

1. Stabilization of Crypto Money Supply

• Unlike the unchecked expansion of UST during 2021, the supply growth of USDe and USDX is carefully managed to prevent hyperinflationary dynamics.
• This controlled growth ensures a more sustainable arbitrage ecosystem.

Risks and Challenges

1. Over-reliance on Stablecoins

• While USDe and USDX offer innovative mechanisms, systemic risks could arise if their models are stressed by extreme market conditions or regulatory changes.

1. Competition and Liquidity Fragmentation

• The proliferation of stablecoins and derivatives protocols may lead to fragmented liquidity, making it harder to execute arbitrage efficiently.

1. Market Saturation

• As more participants enter funding rate arbitrage, returns may diminish due to increased competition, similar to what occurred post-2021.

1. Regulatory Hurdles

• The growing integration of tokenized RWAs and stablecoins into traditional markets could attract stricter regulatory scrutiny, potentially impacting arbitrage strategies.

It is not USDe or USDX makes the funding rate dip faster than 2021 but TradFi hedge funds’ heavy positions on CME after IBIT listing

The pricing of funding rates in the cryptocurrency market is influenced by the @CMEGroup (Chicago Mercantile Exchange) reflects the growing interplay between traditional finance (TradFi) and decentralized finance (DeFi) markets.

How CME Influences Funding Rates

CME as a Benchmark for Pricing

The CME Bitcoin and Ethereum futures contracts are regulated and traded in traditional financial markets. These contracts are often used as a benchmark for institutional players when pricing derivatives, including perpetual futures contracts in crypto-native markets.

1. Since CME futures reflect institutional sentiment and are traded in USD, they serve as a reliable anchor for pricing discrepancies between spot markets and crypto derivatives.

Arbitrage Between CME and Crypto Futures Markets

Traders frequently engage in arbitrage between CME futures and crypto perpetual markets on exchanges like @binance, @okx, @Bybit_Official, @DeribitExchange, and others.

If CME futures trade at a premium or discount to the spot price, it creates arbitrage opportunities that directly influence the funding rate of perpetual futures:

Premium on CME futures: Indicates bullish sentiment, leading to higher funding rates in perpetual futures.

1. Discount on CME futures: Signals bearish sentiment, leading to lower or even negative funding rates.

Institutional Participation Drives Funding Rates

With the CME being a gateway for institutional capital into cryptocurrency markets, its futures prices set a tone for market behavior.

1. Large institutional players often hedge CME positions with crypto-native perpetual contracts, aligning funding rate dynamics with the CME’s futures curve.

Mechanics of CME’s Influence on Funding Rates

CME Basis vs. Spot Price

The CME basis (difference between the CME futures price and the spot price) becomes a key driver of arbitrage flows:

A high CME basis incentivizes traders to go short on CME futures and long in spot or perpetual futures, narrowing the gap and affecting funding rates.

1. A low CME basis (or negative basis) triggers the opposite trade, impacting funding rates accordingly.

CME Futures Expiry

The quarterly expiration of CME futures introduces cyclical patterns in crypto markets:

Leading up to expiry, large-scale hedging activity can affect funding rates as traders rebalance their positions between CME and perpetual futures.

1. Post-expiry, the settlement price of CME contracts often resets market expectations, indirectly influencing perpetual futures pricing and funding rates.

USD Pricing and Market Anchoring

CME futures are denominated in USD, which provides stability and acts as a reference for crypto perpetual contracts, especially during periods of high volatility.

1. This USD anchoring ensures that funding rates reflect not only crypto-native dynamics but also the broader macroeconomic factors affecting traditional markets.

Why CME’s Influence Matters

Bridging Traditional and Crypto Markets

1. The CME serves as a bridge between institutional capital and the crypto market. Its influence ensures that funding rates increasingly reflect broader market dynamics rather than being isolated within crypto ecosystems.

Increased Efficiency and Price Discovery

1. Arbitrage between CME futures and crypto derivatives reduces inefficiencies, ensuring tighter spreads and more accurate pricing in both markets.

Standardization of Derivative Pricing

1. As the CME sets the standard for regulated futures, its impact on funding rates helps align crypto perpetual contracts with more traditional derivative pricing models, making the market more accessible to institutional players.

So please do not blame USDe or USDX, blame TradFi hedge funds for their very low capital costs!

Here are some of the largest shareholders of iShares Bitcoin Trust ETF (IBIT):

Top Institutional Holders of IBIT (iShares Bitcoin Trust ETF)

https://fintel.io/s/us/ibit#:~:text=iShares%20Bitcoin%20Trust%20ETF%20

Some of them are holders, but most of them are actually arbitragers!

Conclusion

The evolution of funding rates and the strategies they inspire highlight the dynamic intersection of TradFi and DeFi. The “Golden Age” of 2021 demonstrated lucrative opportunities but also exposed systemic weaknesses that culminated in significant market crashes. In 2024-2025, the rise of robust stablecoins such as USDe and USDX has ushered in a new era of arbitrage opportunities, offering a more sustainable framework for market growth.

Ultimately, the pricing of funding rates is shaped not by stablecoins but by institutional participation and CME’s benchmark futures. The interplay of these forces underscores the importance of market efficiency, transparency, and robust risk management to ensure the continued maturation of the cryptocurrency ecosystem. Blame for the low funding rates should not rest with stablecoins like USDe or USDX but with TradFi players leveraging their low capital costs and arbitrage strategies.

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