The key role of the Funding Rate is to narrow the price difference between the perpetual futures market and the corresponding spot market (price regression).
2. Why is the Funding Rate so important?
Traditional futures contracts are settled on a monthly or quarterly basis, depending on contract specifications. At settlement, the contract price converges with the spot price, and all open positions expire. Perpetual futures contracts are widely used by crypto derivatives exchanges and are designed to be similar to traditional futures contracts. However, perpetual futures contracts have one key difference.
Unlike traditional futures contracts, perpetual futures allow traders to hold contracts in perpetuity, without expiration dates or the need to track unused delivery months. For example, a trader can keep a short position open indefinitely until the position is closed. In this way, trading perpetual futures is very similar to trading spot market pairs. However, perpetual futures do not use a traditional method of settlement. Because of this, crypto exchanges have created a mechanism to ensure that perpetual futures contract prices match the index price. This mechanism is called the Funding Rate.
3. What is the Funding Rate?
A Funding Rate is a periodic payment made to long or short traders based on the price difference between the market price of the perpetual contract and the spot price. When the market is bullish, the Funding Rate is positive and long traders pay a funding fee to traders who are short. Conversely, when the market is bearish, the funding rate is negative and short traders pay the funding fee to long traders.