Funding payments may be a difficult topic for traders to grasp if they have little experience with derivatives and have only ever traded spot. This article breaks down everything you need to know about funding payments and how they work.
Funding Rates Explained
In contrast to trading futures contracts, perpetual contracts never expire so these instruments need a mechanism to keep the price of the contract in line with the underlying asset. The funding rate achieves this, transferring payments between traders who are long and short a perpetual contract.
Unlike trading spot assets, a position in a perpetual contract cannot be transferred or withdrawn, only the PnL that is generated by the derivative when a position is closed. If you buy a BTC perpetual, you do not actually own any BTC. You just get exposure to the price fluctuations, so unlike trading spot assets, these positions cannot be transferred or withdrawn.
What the funding rate does is to regulate the demand for a perpetual contract to keep it in line with the price of the underlying asset. That’s why when trading perpetuals, there’s actually two prices: the price of the perpetual (known as the mark price) and the index price which tracks the underlying asset.
For example, when traders are bullish on ETH and go long using perpetuals, the mark price will rise as more and more traders pile in. However, this causes the perpetual’s price to diverge from the price of ETH on spot exchanges, tracked by the index price. As a result, the funding rate will be positive in this case and will keep rising if there’s an imbalance between longs and shorts.
Because of the positive funding rate, traders who have bought these perpetual contracts will start making periodic payments to traders on the opposite side of the market, i.e., those who are short the ETH perpetual. For traders who are long, this effectively introduces a cost to holding a long position, which increases in line with position size and disincentivizes more traders from going long.
The positive funding rate effectively incentivizes the opening of new short positions to bring the price of the perpetual back in line with the price of ETH. As more traders go short to earn funding payments, the funding rate starts to fall until the longs and shorts become balanced, equalizing the mark price and index price.
On the other hand, if the market is bearish and lots of traders go short on ETH using perpetual contracts, the funding rate turns negative. That means those holding a short position will carry the burden of the funding payments that go to those traders who are long. As a result, there’s an incentive for traders open long positions and earn funding payments, which should bring the price of the perpetual contract back in line with the index price.
Funding rates are often indicators of market sentiment, since they are dependent on the long-short ratio for a particular trading venue. For example, the funding rate for SOL turned positive on Perp v2 during May 13th, 2022, as the price rebounded after hitting fresh 8-month lows. However, as the market continued lower in the following weeks and as more traders went short, the funding rate dropped near 0%.
There’s also a large spike where the funding rate went into negative territory on the chart above from May 30th, 2022, when many market participants were bearish and positioned short. The price of SOL continued to fall but eventually bottomed out a couple of weeks later and we see another spike, but this time into positive territory as traders shifted into longs.
Notice from the chart that the funding rate tends to quickly revert to zero, as other market participants take advantage of the funding rate by going long when it’s negative or going short when it’s positive, thereby aligning the price of the perpetual with the index price.
Factors that Impact Funding Payments
Other than the funding rate itself, there are a couple of factors that determine how much in funding payments you will pay or receive.
For instance, the larger the divergence between the price of the perpetual contract and the index price, the greater the funding rate will be. As a result, funding payments will be larger too.
In this scenario, there’s a greater opportunity for traders to earn funding payments, which also depends on the size of a position. If the funding rate is positive at 0.02%, then a short position of 10 ETH will earn more in funding payments than a short position of 1 ETH over a certain period of time. But if the rate jumps to +0.04%, then short positions will earn more.
Another factor to consider is how long you want to hold a position for. The longer a short position is held for when funding rates are negative, the more this trader will pay in funding payments. But if you’re just scalping and holding a position for a very short duration, then funding payments aren’t going to make much of a dent in your profit.
If funding rates are positive, the funding payments debited from a trader’s account for holding a long position will start to add up over time. Therefore, it’s important for traders to understand and monitor funding rates.
Going with the trend is likely to incur funding payments from your trading account. On the other hand, being a contrarian and going against the trend could well result in a profitable trade, as well as earning funding payments during the process!
Funding Rates on Perpetual Protocol
Funding payments are peer-to-peer, and are only ever exchanged between traders. Exchanges do not earn any of these fees and the funding rates can vary from one trading venue to another. That’s because the implementation varies across exchanges, with the most common being settled over 8 hour intervals, and there are a different set of market participants in each venue.
On Perpetual Protocol, funding is calculated on a block-by-block basis, and for deeper insights into how funding works on Perp v2, check out this article:
To learn more about funding rates in practice on Perp v2, check out our help center for more on this topic.
Summary
The important things to remember about funding payments are:
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A positive funding rate means longs will pay shorts. A negative funding rate means shorts will pay longs.
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The funding rate will be larger in absolute value when the divergence between the mark price and index price increases.
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The amount you can earn (or will pay) in funding payments will depend on your position size and the length of time you hold your position.
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You are more often than not going to incur funding payments when following the current market trend. Being a contrarian and going against the trend means you are likely to earn funding payments.
Instead of simply going long or short to make a profit, some traders manage to earn a return by utilizing the funding rate to their advantage. In a follow up article, we’ll explain how you can earn funding payments from perpetuals while being hedged.
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