What are funding rates in crypto?

What is a funding rate?

In short, funding rates are designed to encourage traders to take positions that keep perpetual contract prices line in with spot markets. They are a unique financial mechanism pioneered by BitMEx when they first released their perpetual future contract. Due to the nature of it being a non expiring future a mechanism was needed to keep the perpetual contracts price within an acceptable distance from its spot contract.

What determines the funding rate?

The funding rate is derived by two main factors, the interest rate and the premium. The interest rate will be a fixed baseline interest rate that will be paid out every funding interval. The premium is then the difference between the perpetual and spot contract in percentage.

What is a funding interval?

This is the period of time that passes between each funding payment. Usually this is 8 hours but some exchanges pay out more frequently such as 4 hours.

How does funding get paid?

The funding mechanism pays out every funding interval. However the payment can either mean you are being paid or you are paying. ‍

The direction of this payment is determined by your current open position. If a funding rate is positive it means that the perpetual contract is higher than the spot contract, thus at a funding interval longs will pay shorts a funding payment in an attempt to move the perpetual closer back to parity with the spot contract. Alternatively if the funding rate is negative then this means that the perpetual contract is below the spot contracts price and therefore shorts will pay longs. The example below shows a simple scenario of either being long or short against a 0.05% funding rate.

Funding Rate +0.05%

If you are LONG you pay 0.05% of your net open position

If you are SHORT you receive 0.05% of your net open position as payment.

On the other hand if the funding rate was negative then the opposite would occur. It is also important to consider that due to this being paid / received on net open position this can mean that leverage can enlarge these payments. It is important to note that if you are highly leveraged then it is in-fact possible to liquidate yourself in a ranging market if the funding rate is high enough.

Conclusion

Crypto funding rates serve an important role in the perpetual futures market. Most crypto-derivatives exchanges employ a funding rate mechanism to keep contract prices in line with the index at all times. These rates vary as asset prices turn bullish or bearish and are determined by market forces.

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