What are funding rates?
The term funding rates are used quite often in “futures trading” terminology. Today we take a look at what is behind this term.
Funding rates are periodic payments. They are made on behalf of traders in long or short positions. They result from differences between prices on the perpetual futures and spot markets. Depending on the type of open position, traders will either receive “funding” or will have to pay a fee.
Funding rates on the cryptocurrency market help counteract discrepancies in the prices of both markets. The fees usually scale several times a day. The most common practice in exchanges such as a fee for an open position is charged every 8 hours. It’s is the case with Binance and BitMEX.
Funding rates have two components: interest and premium.
The interest rate is usually fixed — the exchange designates it as a percentage of the value of each item. As a result, their values typically oscillate around a few tenths of a per cent.
The premium, in turn, is a variable value. Its value results from the discrepancy mentioned earlier between the price difference of the perpetual futures market and the spot price. To put it simply — a high spread between the markets increases the value of the premium, while a low premium indicates a relatively low spread between the two prices. Thus, funding rates in periods of high price volatility can develop dynamically.
What does the payment process look like? First, when the fixed funding rate is positive, the futures price is higher than in the conventional market — then long traders pay off the short position.
As we wrote earlier, the fee is usually charged on exchanges every 8 hours. An interesting alternative, which at the same time results from the withdrawal from the order book, is offered by Geco.one. In this case, the fee is charged on the open position only once every 24 hours.
How does this process affect traders?
Funding rates can have a massive impact on the final performance of a trader. When using high leverage, an investor paying the funding rate may suffer a loss, which may even lead to the liquidation of his position (despite investing in a relatively stable market). On the other hand, fundraising can be profitable in limited-reach markets. Therefore, traders often monitor funding rates and include their mechanism in their investment strategies.
Most of all, however, funding rates are intended to encourage traders to take positions that keep futures contracts in the same price horizon as the spot markets.