The funding rate is a periodic payment exchanged between traders in a perpetual futures (perps) contract. It is designed to keep the price of the perpetual contract close to the price of the underlying asset (the spot price).
To learn more about perps, go to this article.
Unlike traditional futures, perps don't expire, so the funding rate helps balance demand between long and short positions.
How It Works
Positive Funding Rate: When the perp price is higher than the spot price, traders with long positions (who bet on price increases) pay the funding rate to traders with short positions (who bet on price decreases). This incentivizes more short positions to bring the perp price down closer to the spot price.
Negative Funding Rate: When the perp price is lower than the spot price, short traders pay the funding rate to long traders. This encourages more long positions to raise the perp price back toward the spot price.
Purpose
The funding rate helps maintain price stability by ensuring that the price of perpetual futures stays closely aligned with the underlying asset’s spot price. Without it, there could be large discrepancies between perp and spot prices, especially during volatile market conditions.
Overall, the funding rate plays a crucial role in the mechanics of perps, ensuring market balance between buyers and sellers.