Perpetual Swaps are the most important class of cryptocurrency derivatives and funding is a key characteristic of these contracts. Before diving into the mechanics of funding, it is worth giving a brief introduction to Perpetual Swaps. For an in-depth explanation of Perpetual Swaps, please have a look at this article.
The traditional futures contract has a fixed expiry date. When a futures contract expires its price converges to the price of the underlying asset of the contract, i.e. the spot price. Perpetual Swap Contracts are futures like contracts which do not have an expiry date. Since the perpetual swap contract has no expiry date, its price may never converge to the spot price. That said, the one defining feature of Perpetual Swap Contracts is that they almost always trade close to the spot price. The mechanism through which the price of a perpetual contract is tethered to the spot price is called funding.
Funding is a series of continuous payments that are exchanged between longs and the shorts. When a Perpetual Swap contract price is higher than the spot price i.e. it is trading at a premium, longs pay funding to shorts. Conversely, when the contract price is lower than the spot price i.e. it is trading at a discount, shorts pay funding to longs.
When a Perpetual Swap contract is trading at a premium, longs pay funding to shorts. Thus, there is an incentive to go short to earn funding. As more traders go short, there would be a downward presume on the price of the contract, bringing it closer to the spot price.
Similarly, when the Perpetual Swap contract is trading at a discount, shorts pay funding to longs. Thus, there is an incentive to go to long to earn funding. As more traders go long, there would be an upward presume on the price of the contract, bringing it closer to the spot price.
So, funding continuously pulls the price of a Perpetual Swap contract towards the stop price. The Funding Rate is computed as an 8 hourly rate, calculated once every 8 hours, and is exchanged every minute. However, funding transactions are included in the transaction logs only once every 2 hours.
It is important to note that on Delta Exchange, the funding takes place between longs and shorts directly. Funding exchanges are peer to peer transactions and Delta does not earn any commissions on them.
Funding Rate is considered to be an 8-hourly rate and is the sum of two terms: (a) Avg Premium and (b) Interest Rate.
Premium is computed every minute using the formula presented below. Avg Premium is its 8-hour TWAP (time weighted average price) is used in the calculation of Funding.
Premium =(Mark Price – Underlying Index Price) / Underlying Index Price
The Interest Rate term in Funding calculation is a function of the differential of borrow rates of quote currency and base currency of the perpetual contract. The Interest Rate thus is a proxy for cost of holding a position in a perpetual contract.
Since borrow rates for different currencies can vary widely, the Interest Rate used in Funding calculations can vary from contract to contract. However, as of now, Interest Rate of 0.01%/ 8 hours is being used for contracts.
Funding Rate is computed using the following formula:
Funding Rate = Avg Premium + clamp(Interest Rate – Avg Premium, 0.05%, -0.05%)
The clamp function limits the value of (Interest Rate – Avg Premium) term to a band of (-0.05%, 0.05%).
Lets analyse the three possibilities here (given Interest Rate = 0.01%)
a. Avg Premium is between -0.04% and 0.06%: Funding Rate = 0.01%
b. Avg Premium is above 0.06%: Funding Rate = Avg Premium -0.05%
c. Avg Premium is below -0.04%: Funding rate = Avg Premium + 0.05%
The magnitude of Funding Rate has an upper limit of Funding Cap. This means at any instant Funding Rate can range between [-Funding Cap, Funding Cap] only. Funding Cap can vary from contract to contract and is available in the contract specifications.
Funding Payment = Current Position Value*Funding Rate*1/ (8*60)
where, the Current Position Value is the value of a position at the current Underlying Index Price.
You can see the funding rate history for a selected perpetual contract by selecting the ‘Funding’ tab in the chart.