Trading crypto comes in various forms such as spot and futures trading. Within futures trading, there are two types: traditional futures contracts and perpetual futures contracts. Most retail traders typically use perpetual futures contracts because they have a mechanism called the funding rate that doesn’t require a settlement process. In this article, we’ll discuss what the funding rate is and why it’s important for futures traders. Read on for more details.
Before discussing what the crypto funding rate is, the introduction above briefly mentioned traditional futures contracts & perpetual futures contracts, both of which are related to the funding rate.
Traditional futures contracts are where buyers and sellers of future contracts meet and drive the contract price toward the spot market price by taking long or short positions. This trading occurs throughout the day in traditional financial markets. Traditional futures contracts typically have a settlement process where the trade becomes final on the settlement date and the buyer must pay the seller. This settlement process is usually completed on a monthly or quarterly basis.
Unlike traditional futures contracts, perpetual futures contracts are trades based on the same principles as traditional futures. The main difference is that crypto exchanges such as Binance and Bitfinex offer perpetual contracts, allowing traders to hold a position without an expiration date. This can eliminate the need to worry about settling the contract on a specific date.
Because perpetual futures contracts don’t have an expiration date, some exchanges use a mechanism to ensure that the future price and the index price meet periodically. This method is known as a funding rate.
Now that we understand the two types of futures contracts, we will discuss what the funding rate is. The funding rate is the difference between the price of a perpetual futures contract and the index price that corresponds to the spot market price of the underlying asset. The funding rate ensures that the funding mechanism aligns the price of the perpetual futures contract with the index price. This alignment is intended to prevent prolonged price divergence between the two markets.
The funding rate can be said to have a straightforward calculation method in most exchanges. The way to calculate the funding rate is as follows:
Funding rate = Premium Index (P) + clamp (Interest Rate (I) — Premium Index (P), 0.05%, -0.05%)
Clamp is used with a ceiling and floor of 0.05% and -0.05%, respectively. Thus, if (I – P) falls within +/- 0.05%, then F = P + (I – P) = I.
To better understand this formula, consider the following: Interest rate contracts are traded with a base currency and a comparison currency (e.g., BTC – base, USD – comparator), and the interest rate is a simple calculation between the two that applies as follows:
For example, exchanges like Binance and Bybit have a USD interest rate of 0.06% and a BTC interest rate of 0.03%, so there’s a difference of about 0.03%. The funding rate interval for most exchanges is 8 hours, so the interest rate is as follows= (0.06-0.03) / (24/8) = 0.01% (magic number).
The funding rate has two components, the interest rate and the premium. The interest rate is fixed, while the premium can vary based on the price difference between the perpetual futures contract and the market price.
Essentially, the funding rate creates a cost for one side of the trade and a discount for the other side. It acts as an incentive to keep the perpetual futures contract close to the spot price.
The funding rate can be positive or negative, affecting the sentiments derived from these values, including
By knowing the funding rate, we can gauge the state of the market. The funding rate often reflects the state of the market, with a higher positive funding rate indicating bullish market sentiment. Conversely, negative funding rate indicates a bearish trend.
There are four types of strategies that involve the use of the funding rate in trading, which are
The funding rate can help align the perpetual rate with the spot price of crypto. By studying the funding rate, you can understand the elements that can affect the rate without having to calculate the rate for each transaction, as the exchange will do that for you.
The funding rate can be a powerful metric to determine the future price of a crypto asset. However, the funding rate should be used in conjunction with other metrics to more accurately predict market direction. That’s where the role of traders and investors comes in, to do more research before deciding to invest.