In the digital currency market, there is a concept called futures contracts. This concept applies to contracts that settle and expire on a specific date and price. After the maturity of the contract and the beginning of the settlement process, witness Price convergence In futures and spot market contracts, they reach one number. There is another type of contract called permanent contract which is not settled in the traditional way. In the exchanges that use this contract, they use a mechanism or an index called Funding Rate to control the price ratio in the futures and spot markets. In this article, we are going to get to know the concept of funding rate index and how it is calculated and works in the digital currency market.
What is Funding Rate?
In order to better understand the funding rate and how it works, it is better to first familiarize ourselves with the two types of futures and permanent contracts in the digital currency market. Regarding funding rate and its literal translation, it can be said that it means funding rate or budgeting rate.
Future contract in the cryptocurrency market
Traders in the cryptocurrency market use a futures contract to predict the price of an asset on a specific date. Traders can use this feature and predict the price of an asset, buy and sell future contracts related to it. The most important component in future contracts Time because all these contracts have a due date that has been agreed upon by both parties. In this type of contracts, as the contract maturity gets closer, the price of the asset converges in both futures and spot markets. In other words, in future contracts, the date and the settlement process are two factors that can control prices and may be done weekly or monthly.
Permanent contract in the cryptocurrency market
Perpetual contracts are another type of future contracts that we will learn about to better understand the concept of funding rate. Permanent contracts are generally the same as futures contracts, and the most important and only difference is the absence of a maturity date for the contract. In fact, traders in the cryptocurrency market can enter into a contract and hold it for a longer period of time, regardless of the maturity time. Due to this feature, permanent contracts that are not traditionally settled must have a mechanism such as funding rate that can regularly converge futures prices and spot prices.
How does Funding Rate work?
As mentioned, the funding rate is a mechanism that causes the convergence of asset prices in the futures and spot markets. But how does this index work? Traders in the digital currency market are known as receivers or payers of funding rate according to the value and price of their assets, as well as the positions or situations they have. The financing rate is paid periodically to the holders of long or short positions according to the price difference between the permanent contracts and the spot price.
For better understanding, we explain this mechanism by mentioning an example. Imagine that Bitcoin has a higher price in the futures market than in the spot market. This means that according to traders’ predictions, the price of this asset will increase in the future. As a result traders Borrow purchase done and enter the long position. Now, in this situation, in order to bring the price of Bitcoin closer in the two markets, the buying pressure of traders should be reduced, compared to keeping their position or entering a long position.
On the other hand, there should be an incentive for the short position holders to maintain their position or reduce the asset price in the futures market by registering a new borrowing sale contract. In this situation, the market operator deducts a percentage from the long position holders and adds it to the short position holders in order to approach the asset price in the market.
Now, if the price of an asset such as Bitcoin is lower in the futures market than in the spot market, all the conditions mentioned above are reversed and the market operator deducts a percentage as a funding rate from the short position holders and adds it to the long position holders. .
How to calculate funding rate
Regarding the way of calculating the funding rate in the cryptocurrency market, it should be said that its application and calculation is done at specific time intervals. Although the calculation method may be different in exchanges, the duration of 8 hours is the most common time interval in most exchanges. For example, BitMEX exchange to calculate funding rate Order book depththat is, it considers the amount of buying and selling of an asset at different price levels.
In FTX exchange, a simpler method is considered to calculate this rate. In this exchange, a variable including the last traded price, the highest price offered for purchase (Bid) and the lowest price for sale (Ask) is considered. There is another method to calculate the funding rate that is used in the Binance exchange. In this method, two main components are used to calculate this rate, which includes the interest rate and the premium rate in the desired asset.
How to calculate the premium rate
The premium rate is the difference between the spot market price and the permanent contract, and the following method is used to calculate it in most exchanges.
The premium rate is the price difference between the spot price and the actual price. The premium in most exchanges that use this method is calculated as follows:
Premium Index (P) = [Max(۰, Impact Bid Price – Price Index ) – Max(۰, Price Index – Impact Ask Price)] / Price Index
How to calculate the interest rate
The degree of people’s willingness to enjoy a basic asset is known as the interest rate in future and permanent contracts. For better understanding, we explain this concept by mentioning an example. Assume that one’s underlying asset is Bitcoin and its futures contract is based on the dollar, which in this case is BTC/USD. Suppose here there is a trader who predicts a future increase in the price of bitcoins, who needs to demand more dollars to buy bitcoins. It is in this situation that the demand for the dollar increases and as a result its interest rate increases. The reverse of this situation is also true in that, if the price of Bitcoin is supposed to decrease in the future, the demand for Bitcoin in the market will increase, which will increase its interest rate. In Binance exchange, in order to calculate the funding rate, a fixed interest rate is considered. Therefore, according to the explanations provided, the funding rate is calculated based on the following formula:
Funding Rate (F) = Premium Index (P) + clamp (Interest rate – Premium Index (P), 0.05%, -0.05%)
In the second part of the above formula, an adverb called Clamp , which limits the values inside the parentheses. In fact, if the difference between the interest rate and the premium exceeds 0.05, the number 0.05 is selected by the Clamp function as the premium rate, in which case the funding rate is equal to the interest rate. If the difference between the interest rate and the premium is less than negative 0.05, the result will be the opposite and the funding rate is equal to the premium rate. In the third case, if the difference between these two rates is between negative 0.05 and positive 0.05, the funding rate will be calculated based on the above formula.
What is the use of Funding Rate?
The main and most important application of funding rate in the digital currency market is the convergence of asset prices in the futures and spot markets. Accordingly, this rate can be a positive or negative number. Undoubtedly, if we look at the cause of positive or negative funding rate from the point of view of mathematics, the difference in the price of an asset in futures and spot will be the main factor. But with a deeper look at this issue, we can consider a relationship and correlation between this rate and market sentiment.
With a close look, we can see that when the market is in a bull market, the funding rate tends to be positive and in a bear market, it tends to be negative. In simpler words, when the market is in a bullish mode, it is more likely that traders believe that the upward trend and increase in the asset price will continue, which makes them enter a long position. These conditions cause the asset price to increase in the futures market and as a result the funding rate also increases. But in the case of a bear market, when the market is in a bearish state, traders enter into a short position by anticipating a downward trend and a decrease in the asset price, which results in a decrease in the asset price in the futures market and a decrease in the funding rate.
Types of funding rates
The main and most common type of funding rate is in the form that a certain amount of it is exchanged between the holders of long and short positions in the market in the form of cash, which is mostly used in centralized exchanges. There is another type of funding rate that is used on a platform called Opyn. This platform, which implements derivatives and options in the DiFi space, uses a mechanism called In Kind for funding rates. This mechanism is such that changes in the value of contracts are included and there will be no cash flow between users.
Funding Rate; Asset price convergence mechanism
Due to the difference in the way of settlement in future contracts and permanent contracts, it is necessary that the price of an asset converges and approaches each other in the futures and spot markets. For this purpose, a mechanism called funding rate is used. Using this mechanism, if the difference in the price of an asset between futures and spot increases, market operators control the price of the asset by reducing the percentage of long position holders and adding to short position holders or vice versa. In this article, we tried to familiarize you with the concept of funding rate, its importance and impact in the cryptocurrency market and how to calculate it.
What is Funding Rate? How to calculate the Funding Rate for the first time on the Wallex blog. appeared.
