Funding payments are periodic payments between traders. These are designed to reduce the discrepancy between the perpetual market price and the spot market price.
What Is Funding Payments?
Funding payments are used in cryptocurrency derivatives exchanges for perpetual contracts to drive the trade price closer to the index price of the underlying asset.Since a perpetual contract is a derivative, its price isn’t always the same as the underlying asset. As an example, during a bull market, the price of a BTC perpetual contract is usually higher than the price of BTC in the spot market, because people tend to be more bullish and expect the price to keep going up.
To reduce the price discrepancy between the perpetual market and the spot market, derivatives exchanges adopt a mechanism called “funding payments”. The way funding payments work is that there are automatic payments between traders at fixed intervals (e.g. every hour, or every 8 hours) where traders on the more popular side (the long side during a bull market) pay the less popular side (the short side during a bull market). By doing this, people are incentivized to open a position on the less popular side, hence driving the price toward the spot price.
It differs from one trading venue to another, but normally, funding payments are calculated by the notional value of a trader’s position multiplied by a rate that reflects the price discrepancy in a given interval (1 hour or 8 hours). This rate is also known as the “funding rate”. The greater the price discrepancy in a given interval, the higher the funding rate will be. These rates are positive when the contract price is above the spot price, in which case short position holders receive funding payments from long position holders. When the rates are negative, long position holders receive funding from short position holders.
The funding rate effectively implies a cost of capital and the steepness of the futures curve, and indicates trader sentiment on a given exchange. It is not an interest charge nor a fee that traders pay to hold the position. The rates may vary freely depending on market conditions. Some exchanges place limits to prevent traders from facing extreme rates.
Author: Yenwen Feng – Co-Founder at Perpetual Protocol
Yenwen Feng is a cryptocurrency and technology professional with vast experience as a CEO and co-founder of several startups. Since 2004, Yenwen founded Decore (Stripe Atlas for Crypto Companies), Cinch Network (Decentralized Derivatives), Cubie Messenger (Mobile Messenger, 500 Startups B5, 10M downloads), Gamelet, and Willmobile (Top mobile financial service app in Taiwan, acquired by Systex). Since 2019, Yenwen’s acted as CEO and co-founder of Perpetual Protocol, a decentralized perpetual contract protocol.