Understanding Funding Payments
Perpetual contracts, being derivatives, do not always maintain the same price as the underlying asset.
This is due to the prevailing optimism and expectations of further price increases.
Exploring the Role of Funding Payments
To bridge the price gap between the perpetual and spot markets, derivatives exchanges adopt a mechanism called “funding payments.”
These payments involve automatic transfers between traders at fixed intervals, such as every hour or every 8 hours.
This incentivizes traders to take positions on the less popular side, gradually driving the price closer to the spot price.
The Role of Notional Value and Funding Rates
The calculation of funding payments varies across different trading venues. Still, it typically involves multiplying the notional value of a trader’s position by a rate that reflects the price discrepancy within a given interval.
This rate, known as the “funding rate,” increases with a higher price discrepancy.
Conversely, negative rates imply that long-position holders receive funding from short-position holders.
Funding Rates in Derivatives Trading
Moreover, it provides insights into trader sentiment on a particular exchange.
It is not an interest charge or a fee incurred by traders for holding a position.
The rates can fluctuate freely based on market conditions, although some exchanges impose limits to prevent extreme rates.