Perpetual futures

Perpetual futures are like traditional futures with one important difference: they don’t have an expiration date. You can hold your position without thinking about maturity date and delivery. That perpetuals don’t expire means that there should be a mechanism ensuring that perpetuals prices won’t diverge from the prices of underlying assets. This is where funding rate enters the play. Funding rate helps perpetual price converge to the price of the underlying asset.

Funding rates

The prices of a perpetual contract and of the underlying asset are called mark and index respectively. If the perpetual is trading at a premium to the index (i.e., perpetual price is higher than the underlying asset price), to hold the perpetual is better than to hold the coin itself. That’s why longs will pay short an amount that corresponds to the divergence of the mark from the index. This is also called a positive funding rate. Conversely, a negative positive rate is something that shorts owe longs. This happens when the mark is trading lower than the index.

Let’s say, ETH price is $1,700 while ETH-PERP is trading at $1,710 currently. The perpetual is trading at a discount the index which means that there is a positive funding rate of 0.59%. ( (1710-1700) / 1700 )

If the dislocation of the mark from index price lasts too long, the arbitrageurs can exploit it by taking opposite positions in the perpetual and the underlying asset. In this example, a trader could short ETH-PERP and buy ETH. The sell pressure on the overvalued (expensive) asset and the buy pressure on the undervalued (cheap) asset will cause the prices to converge. Thus, the trader will earn the funding rate on (almost) the risk-free trade.

Funding rates are determined by the market. If traders are more inclined to be leveraged on the long side, then there will be a demand for buying the perpetual contract. This implies that the mark (perpetual’s price) will trade at a premium to the index (the underlying asset price) which cause the funding rate to be positive. Conversely, the demand to be leveraged short will cause the perpetual to trade at a discount to the underlying asset. Thus, the funding rate will be negative.