Understanding Funding Payments
In cryptocurrency derivatives exchanges for perpetual contracts, funding payments play a crucial role in aligning the trade price with the index price of the underlying asset.
Perpetual contracts, being derivatives, do not always maintain the same price as the underlying asset.
For instance, during a bull market, the price of a BTC perpetual contract is typically higher than the spot price of BTC.
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.
Traders on the less popular side of the market (short side during a bull market) receive payments from traders on the more popular side (long side during a bull market).
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.
Positive rates indicate that short position holders receive funding from long position holders when the contract price exceeds the spot price.
Conversely, negative rates imply that long-position holders receive funding from short-position holders.
Funding Rates in Derivatives Trading
It’s important to note that the funding rate serves as a cost of capital and influences the steepness of the futures curve.
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.