Good day everybody,
Welcome to CryptoGod-1's blog on all things crypto. Today we are going to have a quick look at an interesting topic which can be somewhat confusing to some users. Crypto Derivatives, or Futures as they are also known, are perpetual contracts which exchanges offer with no fixed expiry date. Traders do not need to keep an eye on the end date of the contract, instead set a target price for closing their position. In essence this means a trader can hold their position for an indefinite amount of time until they get liquidated. Due to the fact perpetual futures contracts never settle in a traditional sense, exchanges make use of a mechanism to ensure that futures prices and index prices converge on a regular basis. This is known as a Funding Fee.
What is a Funding Fee
A funding fee is a payment either to traders that are long or short based depending on the sentiment of the market and the difference between perpetual contract markets and spot prices. This basically means that traders who have an open position when a funding fee takes place will either pay or receive from the finding fee. This is done to prevent divergence in the lasting price of both the perpetual contract and spot markets.
What Determines this Fee
The fee itself is made up of two separate parts, the interest rate and a premium. Using Binance as an example as it is one of the most popular exchanges in the world and offers perpetual contracts under its Futures section, they apply a fixed interest rate of 0.03% daily. This is broken into three intervals of 0.01% each. Some contracts such as BNBUSDT are exempt and therefore have a 0% interest rate. The premium rate of the fee will vary depending on the difference between the perpetual contract and mark price.
This is because when there is high levels of volatility in the market, the price of the perpetual contract and the mark price can be significantly different. This cause the premium fee to increase or decrease accordingly. The higher the difference between the perpetual contract and the mark price, the higher the premium. Similarly, the less difference between perpetual contract and the mark price, the lower the premium.
The most interesting and likely unknown fact regarding the funding fees are that they are paid peer-to-peer. This means that Binance takes no money from the fees, instead they are used to help balance the market by being paid directly between users. This is done via two types of funding fee, known as positive and negative.
Positive and Negative Impact of the Funding Fee
There are two specific types of rates when it comes to funding fees. These are known as positive and negatives rates, or rates above 0 and rates below 0. The positive funding happens when the price of the perpetual contract is higher than the mark price. The negative rate takes place when perpetual prices are below the mark price.
Positive Rates
- These rates are an indication that traders are bullish in the market, and those with long positions will pay their fee towards those with short positions.
- Users with a short position will see the fee added to their margin, while users with long positions will pay the fee from their margin.
Negative Rates
- These rates imply that traders are bearish and when the fees are taken, those with short positions pay their fees towards those with long positions.
- Users with long positions will see the fee added to their positions margin, while users with short positions will pay the fee from their margin.
When you receive a fee via funding it is applied to your positions margin, meaning the size of your margin will increase. This will raise the spread between your positions current price and its liquidation price. At the same time, when you end up paying a fee for funding, the margin of your position will decrease, leading to a quicker chance of being liquidated.
Traders need to be aware of the time when the fee will take place and whether they are in a negative or positive funding fee. Negligence in paying attention to this can see users loosing their positions via getting liquidated because the change in their margin will always change the liquidation price of their open contract. On the other side of this traders can benefit from collecting funding, which can be quite profitable in range-bound markets.
Essentially, these funding rates were designed to encourage traders to open positions, which will therefore keep perpetual contract prices line in with spot market prices.
Below is an example of the BTCUSDT from Binance where a positive funding fee is being shown, as I have highlighted in orange. A negative fee would be shown as -0.0100% if my open position was long instead of short.
Conclusion
Due to the fact exchanges offer perpetual contracts with no fixed expiry, exchanges have incorporated a funding fee system to ensure hat futures prices and index prices converge regularly. There are two types of funding fees, the positive and the negative rate, and both of these fees incorporate the fixed fee and premium within them. Positive fees are for users who are trading against the prevailing trend, with long positions getting the fees during a bearish pattern, and short positions getting the fees during a bullish pattern. Fees help to keep the perpetual futures contracts price in line with the spot market price. Traders can make use of strategies to benefit from funding fees to increase their profits by placing positions before the fee is due, increasing their margin from the off. There are always risks associated with trading perpetual futures contracts but understanding how the specifices of the system works, including the funding fees, can enhance the experience and profits for a trader.
I hope you enjoyed this piece and learnt something new within it. Have a great day.
Peace. CryptoGod-1.
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