Traditional Futures Contracts VS Perpetual Contracts
To clarify this concept, it is best to begin by highlighting the differences between these two financial instruments. Traditional futures contracts always have an exact expiration or settlement date. Although its price deviates from the underlying asset’s price (basis) during its lifetime, they will always converge at expiration.
Perpetual contracts on the other hand, never expire and never settle in the traditional sense. As such, their prices could end up becoming wildly different than the underlying assets that they derive their value from. To prevent this from happening, a Funding Rate mechanism attempts to tether a contract’s price to its asset’s price.
How does a Funding Rate help tether prices?
The concept becomes more intuitive as you being to understand the process. The funding rate is calculated by considering the interest rates for both trading pair currencies and the Premium Index. The calculation either yields a positive (longs pay shorts) or a negative (shorts pay longs) funding rate. Every 8 hours payments are exchanged with the funding rate deciding who pays who. This exchange of payments causes the Last Traded Price to move closer to the Mark Price.
Let’s imagine that the current Last Traded price for a product on our exchange is significantly higher than the Mark Price. Logically, this means that there are more traders with long positions. As such, they will probably end up paying short position holders at the time of funding. Because traders are aware of when funding will occur, they then become less likely to want to hold these positions and more likely to sell. Hence, the Last Traded price will continually drop and approximate the Mark Price.
Key Points
Funding Rate fees are only paid between traders and not collected by the exchange at all.
It is intended to help tether a perpetual contract’s price to the mark price.
The rate can vary depending on the market.
It is a mechanism that only applies to perpetual contracts and is used by all exchanges that deal with these type of derivatives.
If you would like to learn and read more about how Funding Rates are calculated and applied, please visit our Funding Rate Trading Guide article.
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