Funding Payments

November 21, 2023 - Around 3 mins mins to read

Understanding Funding Payments in Cryptocurrency Derivatives Exchanges

Funding payments are of utmost importance in cryptocurrency derivatives exchanges, especially in perpetual contracts. The main objective of funding payments is to align the trade price with the index price of the underlying asset.

Perpetual contracts, being derivatives, do not always have the same price as the underlying asset. For example, in a bull market, the price of a BTC perpetual contract tends to be higher than the price of BTC in the spot market. This difference arises due to the prevailing bullish sentiment and the anticipation of further price increases.

To bridge the price gap between the perpetual market and the spot market, derivatives exchanges utilize a mechanism called “funding payments.” These payments involve automatic transfers between traders at fixed intervals, such as every hour or every 8 hours. During a bull market, traders on the less popular side (the short side) receive payments from those on the more popular side (the long side). This encourages traders to open positions on the less popular side, thereby bringing the contract price closer to the spot price.

The calculation of funding payments varies among trading venues, but it generally involves multiplying the notional value of a trader’s position by a rate that reflects the price difference within a given interval (e.g., 1 hour or 8 hours). This rate, commonly known as the “funding rate,” increases with a higher price difference. When the contract price exceeds the spot price, short position holders receive funding payments from long position holders. Conversely, when the rates are negative, long position holders receive funding from short position holders.

It is important to emphasize that funding rates do not represent interest charges or fees for holding positions. Instead, they indicate the cost of capital and the steepness of the futures curve, providing insights into trader sentiment on a particular exchange. These rates can freely fluctuate based on market conditions, although some exchanges impose limits to prevent extreme rates.

Author: Yenwen Feng – Co-Founder at Perpetual Protocol

Yenwen Feng is an experienced cryptocurrency and technology professional, having served as CEO and co-founder of multiple startups. His notable ventures include 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 has been actively involved as CEO and co-founder of Perpetual Protocol, a decentralized perpetual contract protocol.