Funding Rate
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Perpetual swaps introduced the idea of a futures contract that does not expire. While in futures the prices of the contract converge towards spot prices as the contract settlement date approaches, perpetual swaps manage to keep contract prices close to spot prices through what is known as a funding rate.
The funding rate is a fee charged to perpetual swaps holders depending on the premium/discount and the positioning of contract holders. If the price of a perpetual swap is at a premium (price of perpetual swap > spot price), holders going long pay short holders this fee. The inverse is also true. By charging the funding rate, contract holders are incentivized to keep prices at a stable price relative to spot prices.
The size of the funding rate is a function of the price premium/discount in comparison to an index of spot prices. The index price used for each derivatives contract usually varies by exchange. The funding rate is typically charged every 8 hours.
Since the funding rate varies depending on the premium/discount relative to spot prices, it tends to spike following a large price movement when these differences are exacerbated. This is useful to notice as increases in the funding rate denote bullish positioning by perpetual swaps traders.
For example, on July 26 and 27 following a 10% rally in Bitcoin, funding rate in large derivatives exchanges quickly rose. This is a result of traders pushing perpetual swaps prices higher than spot prices. Therefore, this difference can be interpreted as bullish positioning from perpetual swaps traders. Over time these premiums are corrected as the funding rate creates a financial incentive for long holders to close their positions (to avoid paying funding fees) or for traders to short sell (and receive the funding fees).
Ultimately, the funding rate can be used to gauge investor positioning and expectations short-term. As well, it is helpful for people looking to trade perpetual swaps to estimate the amount of fees they would have to pay or earn by trading these contracts.
