Funding is the primary mechanism which tethers price of a perpetual contract to spot. Funding is a series of continuous payments that are exchanged between longs and shorts in a perpetual contract. Let’s understand how funding helps keep price of the perpetual contract close to the spot price.

Perpetual contract price > Spot price

When a perpetual contract trades at a premium to spot, funding tends to be positive, i.e. longs pay funding to shorts. This creates disincentive to stay long or enter into a new long position. Conversely, it creates incentive to stay short or enter into a new short position. These dynamics will serve to push the price of the perpetual contract down towards the spot price.

Perpetual contract price < Spot price

When a perpetual contract trades at a discount to spot, funding tends to be negative, i.e. shorts pay funding to longs. This creates disincentive to stay short or enter into a new short position. Conversely, it creates incentive to stay long or enter into a new long position. These dynamics will serve to push the price of the perpetual contract up towards the spot price.