Funding rates are something that exist only in perpetual futures markets. Whilst being a concept that is relevant on a practical level to traders, many investors and analysts like to track funding rates because they can be strong signals of market sentiment.
What Are They
Funding rates are periodic payments paid by one side of a perpetual futures contract to the other. (Worth noting, the funding rate is not a fee charged by the exchange.)
Because perpetual futures contracts have no expiry date, their prices can diverge from that of the underlying asset. Funding rates help keep contract prices as close as possible to the spot price.
The funding rate is determined based on calculations involving:
- the interest rate; and
- the premium.
The interest rate is determined by the operator of the futures trading venue. As for the premium, it adjusts depending on the difference in price between the perpetual futures contract and the spot price. (Some exchanges use mark price instead of spot price. Mark price is a reference price that is usually calculated as a weighted index spot price of an asset across multiple exchanges, lowering the opportunity for price manipulation.)
Interpreting Funding Rates
When a perpetual contract’s price is above spot price, the funding rate will be positive (e.g. 0.02% or 2 basis points). When the funding rate is positive, long traders are paying short traders to have their position open.
On the other hand, when a perpetual contract’s price is below spot price, the funding rate will be negative (e.g. -0.02% or -2 basis points). When the funding rate is negative, short traders are paying long traders to have their position open.
For those interested solely in using funding rates as an indicator of market sentiment:
- Positive funding rates are often associated with bullish market conditions
- Negative funding rates are often associated with bearish market conditions
In addition to whether the funding rate is positive or negative, it is also worth noting its magnitude. For example, consider the difference between a funding rate of 0.25% and 0.02%. As it pertains to Bitcoin, a funding rate of 0.25% is uncommon and a strong indicator of excessive market confidence. A funding rate of 0.02%, however, is far more typical.
Monitoring Cryptocurrency Funding Rates
Funding rates are used by all crypto derivatives exchanges that offer perpetual contracts. The rates are visible on these exchanges’ websites, and most exchanges update their rates every 8 hours.
For example, funding rates on BitMEX are only paid or received by positions open at the end of each 8-hour period, giving traders the option to open or close a position accordingly. As for FTX, its funding rate payments are charged hourly. With dYdX, funding is charged on a per-second basis, preventing traders from strategically closing their positions.