The first part of the series:
Funding rate arbitrage. To understand funding rates, we should first introduce perpetuals. 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.
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.
Funding rates are determined by the market. If traders are more inclined to be leveraged on the long side, which is usually what happens in a bull market, 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 causes 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.
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.
Leveraged delta-neutral yield farming. An example will clarify how leveraged delta-neutral yield farming works. Say, you want to do delta-neutral farming with SOL-USDC pair. First, you deposit $1,000 SOL, and borrow $2,000 USDC which means you have a 3X leverage. You’ll be farming SOL-USDC with $1,500 SOL and $1,500 USDC; thus, you’ll be long $1,500 SOL.
Then, you’ll deposit $3,000 USDC and borrow $6,000 SOL, $1,500 of which will be swapped to USDC. You’ll be farming with $4,500 SOL and $4,500 USDC, and you’ll short $1,500 SOL. Your long and short SOL positions will cancel out, and you’ll be earning return on your $4,000 ($1,000 + $3,000 that you have deposited) which is near neutral.
Spot-future arbitrage. Cash and carry trade, which is a spot-futures arbitrage, was described in my recent article (https://www.publish0x.com/bringing-us-treasurys-onto-the-chain/carry-trading-in-crypto-xxzqdly). When there’s contango in the term structure of futures contracts, deferred month contracts are trading at a premium to spot price. But as the futures contract approaches expiry, its price tends to converge to the spot price. One can buy the asset at spot market and simultaneously short the futures, pocketing the delta-neutral difference.
Futures contracts can have a backwardated term structure as well. For example, before Ethereum Merge event many ETH investors shorted futures to hedge their ETH holdings. This resulted in ETH futures trading at a discount to ETH spot price (which is the definition backwardation). You could buy ETH futures and short ETH spot market.
So, when the term structure of futures contracts is in contango, an investor can pocket delta-neutral profit by going long the asset at spot market and shorting the futures at the same time. Conversely, when the term structure is backwardated, the way to make profit is buy the futures and short the spot market. But note that contango is better for cash and carry trades because shorting the asset at spot market incurs “borrow fee”, which can significantly reduce the profit. Also, not all digital assets are shortable at spot market which makes backwardation less friendly for spot-futures arbitrage trading. Other risks you should be aware of before deciding to do cash and carry trading include:
- Execution risk. If two legs of the trade are executed at different times, this could result in less profit or even in loss.
- Liquidation risk. Too high leverage can lead to the liquidation of the futures contract.
- Trader can experience unrealized loss if the term structure changes.
