A Quick Primer on Funding Rates

A Quick Primer on Funding Rates
what are funding rates

Funding rates are a new concept that only exist in perpetual futures contracts. Because they are critical to the operation of a healthy perpetual futures contract, we thought a quick primer on funding rates would be useful.

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Quick Summary:

  • The funding rate is not a fee charged by the exchange.
  • The funding rate is a mechanism to ensure that the perpetual futures contract price stays near the index price.
  • All crypto derivative exchanges use a funding rate on perpetual contracts.
  • The funding rate is set by the market and varies over time. When the funding rate is positive, Longs pay Shorts. When the funding rate is negative, Shorts pay Longs.

Settlement in traditional futures contracts:

In traditional ‘term’ contracts, futures prices converge to spot prices as the contract approaches settlement:

  • When you trade a traditional monthly or quarterly futures contract, the contract settles at the end of the term. The contract settles to the spot price of the asset at the time of settlement. At settlement you will not have any open position.
  • Over the life of the contract term, the futures contract price will converge with the spot price.

Perpetual futures introduce a new complexity.
The ‘perpetual’ futures contract is similar in principle to a traditional term contract, but the ‘term’ is measured in hours. At settlement, which on Kraken occurs every four hours, the exchange automatically ‘rolls’ your position into the next contract. Because perpetual futures contracts never settle in the traditional sense, market operators need a mechanism to ensure that the contract and index prices would periodically converge. Funding rates serve this role. 

The funding rate is a small fee paid by one side of the contract to the other (e.g. Longs pay Shorts or vice versa).  It’s purpose is to encourage the price of the perpetual futures contract to stay near the underlying spot index price. 

Credit: The perpetual futures contract and the funding rate were invented by Bitmex. 

Historical performance: 

Funding rates tend to correlate with market sentiment. When the market is strongly bullish or bearish, funding rates will tend to be positive or negative, respectively.

Below is a chart of Kraken Futures historical funding rates by day, plotted against the Bitcoin price. The funding rate varies a lot intraday, so to make it easier to see trends we added the dark blue columns, which are a rolling 7 day average of the funding rate.

  • In periods where the market is strongly bearish (e.g. Nov 2018) the funding rate is generally negative and on average Shorts pay Longs. 
  • In periods where the market is strongly bullish (e.g. June 2019) the funding rate is generally positive and Longs on average pay Shorts.  
  • Importantly, the funding rate correlates to changes in price, not the price itself. 

An example: 

Funding rates regularly switch between positive and negative based on market sentiment. For example:

  • The current perpetual futures contract funding rate is 0.0003% per hour  (in purple). So in the current period longs pay shorts.
  • However, the “Est. Next Rate” is negative (-.0069%).  This indicates that in the next four hour period the funding rate will likely flip from positive to negative, and shorts will likely pay longs. 

In conclusion:

  • The funding rate is not a fee charged by the exchange.
  • The funding rate is a mechanism to ensure that the perpetual futures contract price stays near the index price.
  • All crypto derivative exchanges use a funding rate on perpetual contracts.
  • The funding rate is set by the market and varies over time. When the market is bullish, the Longs will tend to pay Shorts. When the market is bearish, the Shorts will tend to pay Longs.

Kraken Futures offers many distinct advantages over the other crypto trading platforms. Get to know and love futures – try out the platform with a demo account or sign up for free!

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Agustin Sanchez