The funding rate is an essential mechanism to allow derivative instruments to track the spot price of their underlying asset.

Since the “digital Sleeping Beauty,” Bitcoin (BTC), woke up about two months after its third halving in mid-May 2020, we have read a lot about the “funding rate” of digital assets futures — from good to completely misleading reports. We just wanted to chime in on that trendy topic.

What is the funding rate?

First, it is important to understand what this “funding rate” is, as it only relates to digital assets derivatives. In traditional finance, futures contracts in which prices are derived from the spot price of the same underlying asset have a predefined expiration: monthly and/or quarterly. Small divergences can occur between the spot price and the future price link to the same instrument, but these divergences disappear when the futures expire, assuring the holder of a future the same price at expiration as the spot price of the same underlying crypto. These divergences tend to be transient, as the futures market is very efficient, and any discrepancy leading to arbitrage between futures and spot prices is quickly removed by experienced traders.

With digital assets, exchanges on which they trade have provided a new kind of futures: perpetual swaps. Perpetual swaps are tradable instruments linked to the spot price of the same underlying asset, mimicking the spot price of the instrument but without detaining it physically, just like traditional futures. However, they differ in the sense that they never expire, thus allowing investors to hold a position for as long as they want — assuming they maintain enough collateral, but this characteristic of futures is out of the scope of this article.

Therefore, an extra mechanism is required to maintain the price of the perpetual swap in line with the spot price of the instrument. This extra mechanism consists of making investors pay extra to hold a perpetual swap position, whose price would be below the spot price otherwise, thus annihilating the arbitrage opportunity or paying them if they’re holding a perpetual swap position that would be otherwise priced above the spot price of the same underlying asset and vice versa. 

This mechanism — i.e., the fee paid or received — is called the funding rate. It is typically assessed three times a day in order to adjust to the market movements. This fee typically ranges between three and 15 basis points per eight-hour cycle.

During strong market moves or periods of high volatility, the price of the perpetual swap can differ more than during quiet/low volatility periods, leading to a higher funding rate in order to reduce/close the gap between the perpetual swap and the spot price.

Let’s have a look at an example of the funding rate. One can see the increasing rate over the last few days of July 2020 when Bitcoin broke out.

How to use the funding rate when trading crypto?

By construction, the funding rate is a lagging indicator of the volatility of the underlying asset, contrary to what we’ve been told. Indeed, the more the spot price moves, the more the funding rate increases and vice versa, but the price always leads the funding rate, not the other way around.

However, the higher the funding rate, the larger the divergence will be between the perpetual swap and the spot price, which confirms strong interest from investors to either buy or sell the underlying crypto.

Increasing volume is also a sign of strong interest from investors, but it can be faked as demonstrated by several studies.

The funding rate can be seen as true confirmation of strong interest to buy or sell the related instrument: A high positive funding rate confirms the buying interest, whereas a high negative funding rate confirms the selling pressure, as was the case mid-March 2020. A diminishing funding rate from the highs means less interest from investors, but it doesn’t mean the price of the underlying asset is about to reverse, meaning quieter movements in the underlying asset.

Astute traders can use the funding rate as an indicator to adjust any potential leverage on a position in two ways. An increasing funding rate means more confirmation of a movement, either up or down according to the sign of the funding rate. Investors can decide to either leverage their position more — as the move of the underlying crypto is strong and expected to last from a few hours to a few days — to take advantage of the move, or if they are already leveraged during normal moves — i.e., confirmed by a low funding rate — they can reduce their usual leverage in order to keep risk exposure more or less stable over time.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, you should conduct your own research when making a decision.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.