This post has no math. Funding rates are explained intuitively with diagrams to aid visualization. This post is a simple high level overview for traders considering using perpetuals and the curious. We’ll leave the details and formulas for a future post aimed at anyone wanting to incorporate advanced trading strategies or build their own perpetuals exchange.
The funding rate makes sure that the perpetual future price closely follows the underlying price. No more no less. Funding should interfere as little as is necessary to perform this function.
What are perpetuals and why bother?
Perpetual futures are by far the most popular derivative in crypto. They improve on traditional futures by doing away with expiry dates. This concentrates all liquidity in a single contract per trading pair and does not require rolling over contracts at expiries.
Funding rates are used to maintain perpetual futures peg to their underlying index. When the prices diverge traders can profit by earning this yield. They also affect the relative incentive to hold long and short positions. This is how they incentivize trading in the direction that will converge the perpetuals price with the underlying price.
Exchanges take no fees from these funding rates. Funding fees are transferred between traders with open positions on the exchange at the end of a funding period. The total net funding paid by traders is zero.
This post introduces an intuitive understanding of how the funding rate is calculated and what it means.
The funding methodology pioneered by BitMex forms the basis for most exchange implementations. There has been little divergence from this other than iterating on certain details and in some cases simplifying the formula. This is the funding implementation we’ll discuss here.
There are two components used to calculate the funding rate.
- Interest Rate Component — natural interest rate of the trading pair
- Premium Component — divergence between the perpetuals price and the underlying price.
Simply put the interest rate component is the natural interest rate associated with the underlying trading pair. This is the rate longs pay shorts when the futures price exactly matches the underlying index price.
The premium component adjusts the interest rate component rate to incentivize traders to bring the futures price in line with the underlying index. If the futures price is above the index price then to incentivize sellers longs will pay additional funding payments on top of the interest rate component to shorts until this normalizes. When the futures price is below the index price the opposite happens.
The diagram below shows how the funding rate changes in response to the perpetual market price moving away from the underlying price. The clamp function, mentioned in most funding rate docs, causes the flat portion at the Interest Rate Component level. This explains the frequent observations at this rate in the Binance BTC Funding Rate chart.
All you need to know about this function really is that it makes the funding rate equal the interest rate component rate when the futures market price is close to the underlying market price.
It’s not necessary to completely understand the funding formula as the intricacies are quite involved. Rather understand the relationship between the funding rate and the difference between the perpetuals price and the underlying price called the premium.
The diagram below uses the same parameters as BitMex and Binance (amongst others). The Interest Rate Component is 0.01% every 8 hours and the max, min rates in clamp are ±0.05%. Don’t worry too much about these details, just know its industry standard at this point.
Note how the funding rate is equal to the Interest Rate Component rate and is not zero when the perpetual market price is in line with the underlying price (premium equals zero). It actually equals the interest rate component when prices are in line.
Many exchanges cap the funding rate to protect maximally leveraged positions from immediate or near-term liquidation.
This can reduce the ability of the market to converge to its underlying price in extreme scenarios and therefore only makes sense for the purpose mentioned above. It could also be another reason to limit maximum leverage in less liquid markets.
As mentioned in the introduction to this post, perpetual futures have been extremely popular in crypto markets. A wide variety of token futures markets are traded across many exchanges.
The diagram below shows the evolution of the BTC-USDT perpetual funding rate on Binance over the past month.
What does this mean. Here are some summary statistics unpacking this:
- The average annualized funding rate is 7.19%. This is 0.0066% per 8 hour period.
- The average premium annualized is -3.76%. This corresponds to an average perpetuals price 0.0034% below the index price. Call that in line.
- 25% of the time the perpetuals price is within the interest rate component: 0.01% ±5bps of the index price over the entire funding period.
- The 8 hour funding period with the largest positive and negative divergences both averaged 9.5bps away from the index price over the funding period.
All round this perpetuals market has clearly tracked its underlying BTC index well over this period.
This post deliberately omits the formula used to calculate funding. The intention is to give an intuitive understanding of how the funding rate reacts to divergences between the perpetual price and the underlying price.
There will be a follow up going deep into the weeds examining every aspect influencing the funding rate calculation. How choices made by exchanges impact trading conditions and possible future improvements.