Perpetual Contracts

In traditional futures contracts, there is an expiration date when the contract settles, and the futures price converges with the spot price. However, perpetual futures, also known as perpetual swaps, have no expiration date or delivery, meaning the contract can theoretically remain open indefinitely.

Funding Rate

To prevent the perpetual futures price from deviating too far from the underlying asset's spot price, a mechanism called the "funding rate" is employed.

The funding rate is calculated based on the premium or discount of the perpetual futures price relative to the spot price. If the perpetual futures price is trading at a premium to the spot price, long positions pay a funding fee to short positions. Conversely, if the perpetual futures price is trading at a discount to the spot price, short positions pay a funding fee to long positions.

This funding rate mechanism acts as a price rebalancing force, encouraging traders to open positions that counter the imbalance between the perpetual futures price and the spot price. By incentivizing traders to take opposing positions, the funding rate helps anchor the perpetual futures price to the spot price, maintaining a more stable and efficient market.

The funding rate is typically calculated and paid out every 8 hours or once per trading day.

Example:

Consider the Bitcoin perpetual futures contract traded on a major cryptocurrency exchange. The funding rate is calculated based on the difference between the Bitcoin's perpetual price and Bitcoin's spot price. If the perpetual futures price is trading at a premium to the spot price, say $100,500 vs $100,000, traders with long positions pay a small funding fee to those with short positions, incentivizing more short positions to open and bring the futures price back in line with spot. Conversely, if the perpetual futures price is at a discount, like $99,500 vs $100,000 spot, short positions pay a fee to longs, encouraging more longs to open and reduce the discount. The funding rate, typically calculated and paid every 8 hours or daily, considers factors like premium/discount levels, open interest, and trading volumes to determine the appropriate fee amount that will help anchor the perpetual futures price to Bitcoin's spot price, maintaining a balanced and efficient market.

Funding Rate Calculation

The funding rate consists of two parts: composite and premium rate.

1. Composite Rate: The composite rate is the baseline funding rate that reflects the difference between the perpetual futures price and the underlying spot price. It is calculated based on the premium or discount of the perpetual futures price relative to the spot price.

Composite rate = (quote currency interest rate – underlying currency interest rate) / funding rate settlement frequency

2. Premium Rate: The premium is an additional component that accounts for the inherent risk associated with holding perpetual futures positions. It is typically a fixed rate determined by the exchange and is paid by long positions to short positions.