Funding Rates in Crypto Futures: Understanding its Impact on Profits & Liquidation Risk

Key Takeaways:

• Understanding that crypto funding rates are used to ensure crypto perpetual future prices remain as aligned as possible to the price of the underlying asset.
• How to interpret crypto funding rate percentage values.
• And, realizing how crypto funding rates impact the crypto futures market on the bullish or bearish side. 

What is the Funding Rate in Crypto?

The funding rate is a system of periodic payments made to either short or long traders in the crypto futures market. It is calculated based on the difference between the perpetual contract price and the spot price of the underlying crypto asset. 

As a rule of thumb, when the market is bullish, the funding rate is on the positive side and tends to rise over time. This is a situation where long traders on the futures contract have to pay a funding fee to the traders on the short side. Similarly, whenever the market is bearish, the funding rate turns negative and tends to go further down as the bearish trend continues. During these phases, short position holders on crypto perpetual futures contracts have to pay a funding fee to the long traders. 

What is the use of the Funding Rate in Crypto? Why is the Crypto Funding Rate important?

A funding rate is a concept that rises out of the fact that crypto futures contracts are perpetual in nature. Since crypto futures contracts are perpetual in nature, the value of these futures contracts cannot be allowed to deviate too far away in either direction from the actual spot price of the underlying crypto asset.

Thus the funding rate in crypto futures becomes the primary force that is used to converge the prices of the perpetual contract and the underlying crypto asset. This is important because, when comparing traditional futures contracts vs perpetual futures contracts, perpetual futures do not have any expiration date. In traditional futures contracts, due to the presence of an expiration date, futures contracts can trade significantly above or below the actual spot price of the underlying. But in the case of a perpetual futures contract, this cannot be allowed as this would create distortion in the market and result in undue losses for traders. Traders can hold on to a perpetual futures contract in perpetuity, as the name suggests, unless the trader gets liquidated or exits the market.

Thus to solve this issue, crypto exchanges that provide futures trading facilities created a mechanism called “funding rates” to correspond to the spot price of the actual underlying crypto asset and ensure that there isn’t too much of a deviation from the futures contract value to the underlying asset.

So, what is the concept of Funding Fees in Crypto Futures?

A funding fee is nothing but the actual dollar amount that is paid out in accordance with the prevailing funding rate in the market at that point in time. It must be noted that no part of the funding fee is taken by the exchange but rather is directly transferred to the recipient trader on the other side of the open futures contract in the market. 

Thus when the market is in a state of contango, meaning the futures contract price is higher than the spot price of the underlying, the funding rate will be positive and the traders holding long positions will have to pay funding fees to traders holding short positions in the crypto market. For example, the funding rate for BTCUSDT perpetual futures, on CoinDCX is about 0.0091%.

On the flip side, when the market is in a state of backwardation, meaning the futures contract price is lower than the spot price of the underlying, the funding rate will be negative and the traders holding short positions will have to pay funding fees to traders holding long positions in the crypto market. 

How to interpret Funding Rates and Fees?

Interpreting funding rates is relatively simple once you understand the concept behind it. So, to revise what we have learned before and apply that as an interpretation:

• Contango – futures contract price is higher than the spot price of the underlying asset.
  • Positive funding rate 
    • Indicator of a bullish market
      • Traders holding long positions pay funding fees to those holding short positions.
• Backwardation – futures contract price is lower than the spot price of the underlying asset.
  • Negative funding rate
    • Indicator of a bearish market
      • Traders holding short positions pay funding fees to those holding long positions. 

Additionally, another aspect to factor into the interpretation of funding rates, be it positive or negative rate, is the magnitude of the funding rate. For example, let’s take an example of two funding rates, one at 0.25% and the other at 0.02%. If we are talking about the Bitcoin futures funding rate, a funding rate of 0.25% is highly uncommon as it signifies extremely high market confidence on the bullish side, in our example. While a 0.02% funding rate is far more typical and understandable in normal market situations.

Read more: Margin vs Futures Trading

Monitoring crypto funding rates across various crypto exchanges

What is the impact of funding fees in the crypto futures market?

Funding fees attempt to bridge the difference between the spot price and the futures contract price by managing pressure on the profits and increasing liquidation risks faced by crypto futures traders and investors. 

• Profits
  If the funding rate increases, there is increased pressure on the profits realized by the paying side of the funding fee. Thus a higher funding rate increases the value of the funding fee which can reduce the profitability of the trader on the profitable side of the trade. However, if a trader is on the receiving side of the fee, which would mean the trader is seeing losses on the books, this funding fee received would help alleviate some of the losses borne by them.
• Liquidation risk
  While funding rates can impact profits, they can also pose a liquidation risk if the trader is not fully aware of it or does not consider it while entering a trade. A high funding fee effectively brings a trader closer to their liquidation value as it eats up his or her margin money, thus bringing them closer to liquidation values as the fee would eat up the trader’s margin and reduce the amount of available margin required to keep the position open.

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Additional crypto futures terminologies you need to know about!

Funding Round: This is the fixed time at which the funding fee is exchanged between traders on the crypto futures market.

Funding Fee Cap/Floor: This is a value that described the maximum amount of funding fee that can be charged to traders during a funding round.

Funding Interval Time: This is the term that refers to the frequency at which the funding fee is exchanged between traders on the exchange. Generally, it occurs once every eight hours, but during periods of high market volatility, the interval can be shortened too.

Conclusion

Thus, in conclusion – funding rates and funding fees play a crucial role in maintaining crypto perpetual futures contract prices in the market. Thus it is advisable for futures traders to keep an eye on and track funding rates, funding fees, and related concepts in this space. This can enable traders to make more informed and better decisions in the heat of the moment and reduce downside risk as much as possible while improving their upside potential on their trades in the crypto futures market. 

CoinDCX Futures provides easy access to the funding rates for all the available crypto futures trading pairs on the platform right on top, above the charts. CoinDCX futures also provides access to other pointers such as time to funding and estimated funding rate on the same panel on the screen for traders to view at a glance. CoinDCX platform allows you to easily trade in various futures markets, ranging from BTCUSDT, ETHUSDT, SOLUSDT and many others.

Read more: 10 Reasons to choose Crypto Futures Trading on CoinDCX