Funding rates are a core element of any perpetual swap product, also known as perpetual contracts. Since perpetuals have no fixed expiration date, these contracts can be held indefinitely.
As a result, the typical convergence of a traditional futures price with the underlying asset price as expiration approaches doesn’t apply to perpetuals.
Instead, perpetuals tether the price of the perpetual contract to the underlying asset’s spot price via funding rates. Funding rates modulate the incentive to trade a given perpetual contract, either long or short, by assigning a positive or negative value to a specific perpetual market.
Positive Funding Rate = Perpetual Mark Price > Spot Index Price
Negative Funding Rate = Perpetual Mark Price < Spot Index Price
Funding rates ensure that the mark price of a perpetual doesn't deviate significantly from the underlying index spot price over time.
If the perpetual price is too high relative to the spot index price, longs pay shorts to incentivize short positions, pushing the price back down. If the perpetual price is too low relative to the spot index price, shorts pay longs to incentivize long positions, pushing the price back up.
The funding rate functions like an interest rate paid by open long or short perpetual positions based on current market conditions and how the funding rate is calculated. Funding rates can make holding long or short positions more costly or advantageous over time, depending on their value.
Funding rates are paid or received proportional to the size of an open market position.
Consequently, funding rates replicate the expiration-based convergence of traditional futures and spot prices without an expiration date. Payments on open positions due to funding rates are only exchanged between traders on each side (e.g., long/short) of an individual perpetual market.
For example:
- If the ETH perpetual funding rate is positive, traders with open long ETH positions pay the prevailing funding rate to those with open short positions for the current funding interval.
- If the ETH perpetual funding rate is negative, traders with open short ETH positions pay the prevailing funding rate to those with open long positions for the current funding interval.
Calculations of the funding rate reflect the open interest of a specific perpetual market. Open Interest = the total of all open positions for an individual perpetuals market
The positive or negative value assigned to a funding rate determines the interest rate payments between longs and shorts within a given funding interval, expressed as a percentage of an open position’s size.
Funding rates are variable, adjusting to real-time market conditions for each perpetual market.
Users should always consider the funding rate of a perpetual market they’re trading. Funding rates can sometimes significantly impact an open position’s PnL based on current market conditions, especially if holding an open perpetual position for extended periods.
