Before dealing with what is funding mechanism, we need to identify what are the mechanics in trading similar future contracts. In trading cryptocurrencies such as (BTC, ETH, XRP, LTC) futures, one thing that we need to consider is an overview of a derivative product called “Perpetual Contracts”. Perpetual Contract has no expiration or any settlement and imitates a margin-based spot market which all trades were close to its Index Price. So the primary mechanism to secure to spot price is funding. And that is why funding mechanism is established.
WHAT IS PERPETUAL CONTRACT AND ITS MECHANICS
Further, traders must be knowledgeable on these several mechanics of the market since we are trading perpetual contracts. The component that every trader must be aware of are: Position Marking, Initial and Maintenance Margin, Funding, and Funding Timestamps.
Position Marking is marked based on its fair marking price. Normally, the process determines the unrealised PNL and its liquidation prices. For example, during our trade we buy long on 10,000 contracts at a price of 8,000 usd . The price is the position marked which then the basis of our unrealized PNL as well as liquidations – so our position marking is based on the actual price of our orders (either limit or market) filled. Sometimes the price on our order will not be the same in all contracts that we executed especially when using market orders. Say only 5,000 contracts was filled on the price of 8,000 usd and the rest was filled on 8,010 usd price – then that’s the time the position marking method took place. Normally the platform would average the price to be the position marking.
Initial and Maintenance Margin is the key level to determine how much leverage one can trade and also the point of identifying its liquidation price. When we are trading, one thing that we need to understand is that we are trading in futures and not on spot market. Moreover, we are not actually trading the actual instrument (such as BTC, ETH) but rather we are trading based on the contracts. Since, it is financial leverage we are borrowing the said funds to trade the amount and in return having greater gains than the normal spot trades. Consequently, the amount of contracts depends upon the original amounts or funds that we entered into the platform. Say we entered 10,000usd to add on our available balance. Thus, this is now our initial margin and the maintenance margin happened during our trades. Liquidations will take limit on the number of contracts we can use to trade. In addition, some traders are applying the rules of 2% (t2 percent) and 6% (6 percent) to be the amount used in every trade based on their initial margin. This is to protect their funds from getting into outright liquidation.
WHAT IS FUNDING AND FUNDING MECHANISM?
Funding is the periodic payments exchanged between the buyer (long entries) and the seller (short entries) which happened every 8 hours. The principle is very simple – when the rate is positive, then longs will pay the shorts and if the funding rate is negative, therefore, shorts pay the longs. The exchange had no intervention with this funding mechanism – it is solely on the buyers and sellers respective trading activities.
Funding as essential element of identifying the characteristics of perpetual contracts, may provide the basis for the amount of premium especially on trades executed by real-time. As per se, when traders are predicting the amount, either way, will pay the amount of premium based on premium index. The amount paid will be derived from computed interest rate on funding schedule. Further, funding timestamps happened every 8 hours, therefore interest will differ on such time period. However, interests are being computed every minute and are averaged on 8 hour time called Time Weighted Average Price (TWAP). Each contract’s Premium Index is available on the specific instrument’s Contract Specifications page and is calculated as follows:
Premium Index (P) = (Max(0, Impact Bid Price - Mark Price) - Max(0, Mark Price - Impact Ask Price)) / Spot Price + Fair Basis used in Mark Price
IMPACT ON PRICE WHEN THERE IS FUNDING
When trading is executed, either party pays the amount for premium based on Time Weighted Average Price (TWAP). Impact on prices may be observed through volumes of transaction during this 8 hour time interval. Therefore, this time price may significantly change as this will be the change of interest for premium index. Many traders will see to it that in case they will pay the amount of premium to their trades, chances would be majority of the traders are against their predictions. Therefore, price could change against them which resulted to loss position and unrealized gain or worse hit their stop loss. In contrast the amount of losses they realized may reduce over the amount of premium they received from the winning traders. Moreover, the amount of gain, winning traders received could potentially reduce on certain amount than the actual winning positions they expect. Therefore, winning traders will pay amounts to losers in funding mechanism; that is one of the disadvantages funding mechanism had.
EXAMPLES AND SAMPLE TRANSACTION FOR FUNDING MECHANISM
Day 1, 10:00 UTC
A trader goes long 15,000 (XXX) base currency and (YYY) quote currency in contracts at a price of 750 YYY. The computation to its position value will be contracts multiplied by the fraction of 1/750 equal 20, as contract stated for example.
Position Value = 15,000 Contracts * 1 YYY * 1/750 = 20 XXX
During the time of 12UTC, funding timestamp, the amount he pays is determined for example as interest quote index of 1% per day and .25% per day for interest base index.
Funding Rate = (1.00% - 0.25%) / 3 (amount of timestamp period as an example) = 0.25%
Funding Amount = Position Value * Funding Rate = 20 XXX * 0.25% = 0.05 XXX
The Funding Amount is positive, therefore since he is long the trader pays and his counterparty who is short receives 0.05 XXX
The XBTUSD contract rose in price to 800 YYY. The trader closes out his position by selling 15,000 XXX contracts. He does this before the next Funding Timestamp at 20:00 UTC and will not need to pay the Funding Amount at that time.
The trader made 1.25 XXX profit from the increase in the value of XXX:
PNL = 15,000 * 1 YYY * (1/750 - 1/800) = 1.25 XXX
The trader exchanged 0.05 XXX in funding, hence the trader’s total profit is 1.2 XXX (1.25 XXX - 0.05 XXX).
CONCLUSION
Funding mechanism is one of the characteristic of perpetual contracts. The third party which is the exchange will not pay the players but always gain out of fees; thus, favorable on market platforms. In connection, all traders who are playing and doing activities in future contracts like perpetual will pay each counterpart during trades of bets and predictions of price movement. It will be beneficial as it will the one dictates potential price action based on the funding of interest premium each timestamp goes live.
