1. Basic concepts and principles of funding rates: the “balance tax” and “red envelope” mechanisms in the cryptocurrency world
1.1 What is a perpetual contract?
In the financial market, arbitrage opportunities between spot and futures markets are not uncommon, and participants ranging from large hedge funds to individual investors can get involved. However, in the 24-hour trading environment of the crypto market, a special derivative product has been born - perpetual contracts.
The core differences between perpetual contracts and traditional futures contracts:
No delivery date: Perpetual contracts do not have a delivery date. Users can hold positions for a long time as long as they have sufficient margin and do not get liquidated.
Funding rate mechanism: The Funding Rate is used to anchor the spot price, so that the contract price remains consistent with the spot index price in the long term.
In terms of pricing mechanism, perpetual contracts adopt a dual-price mechanism:
Mark price: used to calculate whether a position has been liquidated, determined by the weighted average spot price of multiple exchanges to prevent a single platform from manipulating the market.
Real-time transaction price: The actual transaction price in the market determines the users opening cost.
Through the funding rate mechanism, perpetual contracts can maintain long-term market equilibrium without a delivery date.
1.2 What is the funding rate?
Funding Rate is a mechanism used in perpetual contracts to adjust the long and short forces in the market. Its core purpose is to make the contract price as close to the spot price as possible.
In specific calculations, the funding rate is composed of a premium part + a fixed part. The so-called premium refers to the degree of deviation between the real-time transaction price of the contract and the spot index price.
Premium rate = (contract price − spot index price) / spot index price
Fixed rate = base rate set by the exchange
When the funding rate is positive, it means that the contract price is higher than the spot price and the long market is too strong. At this time, the longs need to pay the funding rate to the shorts to curb the excessive optimism of the longs.
When the funding rate is negative, on the contrary, short sellers need to pay fees to long sellers, which curbs excessive pessimism of short sellers.
Funding rate settlement cycle: Generally, settlement is made every 8 hours, which means that users holding contracts need to pay or receive funding rates during each settlement cycle.
1.3 How to understand the funding rate mechanism of perpetual contracts in a simple way
The funding rate mechanism of perpetual contracts can be compared to the housing rental market:
Tenant (Long) = Investor who buys perpetual contracts
Landlord (short) = an investor who shorts a perpetual contract
Average price in the area (marked price) = average price in the spot market
Actual rental price (real-time contract price) = market transaction price of perpetual contract
Example:
If there are too many tenants (bulls) and the rent (contract price) is driven up to a level higher than the market average (marked price), then the tenants will need to pay a red envelope (funding rate) to the landlord to bring the rent down.
If there are too many landlords (short sellers) and the rent is depressed, then the landlord needs to pay red envelopes to the tenants to make the rent go back up.
In essence, the funding rate is a dynamic balance adjustment tax of the market, which is used to punish the party that destroys the market equilibrium and reward the party that corrects the market equilibrium.
II. Funding rate arbitrage strategy: three methods, but the source of income is the same
2.1 Financial Explanation of Funding Rate Arbitrage
The core of funding rate arbitrage is to lock in funding rate income by hedging spot and contract positions while avoiding price volatility risks. Its basic logic includes:
Rate direction judgment: According to the long and short forces, when the funding fee deviates significantly, there is a large arbitrage space
Risk hedging : By holding opposite positions of spot and contract, the risk of price fluctuations is offset and only the funding rate is earned.
High-frequency compound interest : settlement every 8 hours, with significant compound interest effect
In essence , funding rate arbitrage is a Delta-Neutral Strategy, which locks in a specific yield factor (funding rate) without taking on price direction risk.
2.2 Three methods of funding rate arbitrage
1) Single-currency, single-exchange arbitrage (most common)
Specific steps:
Judgment direction: If the funding rate is positive and the long position pays the fee, it is suitable to short the contract and go long the spot.
Establish a position: short perpetual contract + long spot
Fee rate: Assuming that the spot price of the underlying asset rises, the short contract in the portfolio will suffer losses, and the gains and losses of the two will offset each other. However, the long position of the futures contract will need to pay you funding fees and earn funding fee income.
2) Single-currency cross-exchange arbitrage
Specific steps:
Scan exchange funding rates: Select two exchanges with sufficient liquidity and large differences in funding rates
Establishing a position: short perpetual contract (A) + long perpetual contract (B)
Earn the difference in funding fees: Earn the difference based on the different funding rates of the exchange
3) Multi-currency arbitrage
Specific steps:
Choose highly correlated currencies: that is, currencies with highly similar trends, take advantage of funding rate differentiation, hedge the direction through position combinations, and earn profits.
Establish a position: short high funding rate currency (such as BTC) + long low funding rate currency (such as ETH), adjust the position according to the ratio
Earn income: Funding rate difference + volatility income
Among the above three methods, the difficulty increases in turn. In actual practice, the first method is the most common. The second and third methods have extremely high requirements and technical difficulties for execution efficiency and transaction delay. On the basis of the above, leverage can also be increased for enhanced arbitrage, but this requires higher risk control and is also more risky.
In addition, on the basis of funding fee arbitrage, there are also some more advanced practices, such as combining spread arbitrage and term arbitrage to enhance returns and improve the efficiency of fund use. Spread arbitrage refers to arbitrage using the price difference of the same underlying asset on different exchanges (spot and perpetual contracts). When the market fluctuates greatly or the liquidity distribution is uneven, funding rate arbitrage can be combined with spread arbitrage to further improve the yield of the strategy; term arbitrage refers to arbitrage using the price difference between perpetual contracts and traditional futures contracts. The funding rate of perpetual contracts changes with market sentiment, while traditional futures contracts are delivery contracts, so there is a certain spread relationship.
In short, no matter which hedging and arbitrage method is used, it is necessary to fully hedge the risk of price fluctuations, otherwise the returns will be eroded. In addition, costs must also be considered: such as handling fees, borrowing costs (if leveraged), slippage, margin usage, etc. As the overall market matures, the returns of simple strategies will decline, and it is necessary to combine algorithm monitoring, cross-platform arbitrage and dynamic position management to achieve continuous profits; the more advanced arbitrage + spread model has high requirements for transaction execution efficiency and market monitoring capabilities, and is suitable for institutional investors or quantitative trading teams with certain technical capabilities and risk control systems.
3. Institutional advantages: Why can retail investors “see but cannot get”, what is the reason?
Funding rate arbitrage seems to have simple logic, but in practice, institutions have established huge advantages by relying on technological barriers, economies of scale and systematic style.
3.1 Opportunity Identification Dimension: Dimensionality Reduction in Speed and Breadth
Institutions use algorithms to monitor funding rates, liquidity, correlation and other parameters of tens of thousands of currencies in the entire market in real time, and identify arbitrage opportunities in milliseconds.
Retail investors rely on manual or third-party tools (such as Glassnode), which can only cover hourly lagged data and focus on a few mainstream currencies.
3.2 Opportunity Capture Efficiency: Cost Gap under Differences in Technology and Transaction Volume
With the huge advantages of the entire technical system and cost control, the arbitrage profit gap between institutions and retail investors may be several times higher.
3.3 Risk Control System: System-level Risk Response and Artificial Gaming
From the perspective of risk control, institutions have a mature system for controlling position risks and can take timely actions when extreme situations occur. They can selectively reduce risks by reducing positions, replenishing insurance, etc., while retail investors are slow to respond and have limited means when extreme situations occur. The differences are mainly reflected in the following aspects:
Response speed: The response speed of an organization is in milliseconds, and that of an individual is at least in seconds. If you don’t keep a close eye on it, it may even be in minutes or hours. It is difficult to guarantee a quick response.
Risk control accuracy: Institutions can reduce their positions in certain currencies to a reasonable level based on accurate calculations, or choose to replenish margin to a reasonable range, and make dynamic adjustments to ensure that no risks occur; however, individuals lack the ability to accurately calculate and operate, and can basically only choose to close their positions at market prices.
Multi-currency processing: When risks occur and need to be dealt with, institutions can handle at least dozens or hundreds of currencies at the same time, and minimize the operational losses of each currency; individuals can only handle single-digit currencies sequentially and in a single thread at best.
4. Prospects of arbitrage strategies and investor adaptation
4.1 Differences in institutional arbitrage strategies and market cap
Most people would have a question: if all institutions adopt arbitrage, can the market capacity support it and will it reduce the returns? In fact, the entire logic is obviously similar among institutions.
Datong: The same type of strategy, such as arbitrage, has roughly the same strategic ideas;
Xiaoyi: Each institution has its own strategic preferences and unique advantages. For example, some institutions prefer to focus on large currencies and explore opportunities in large currencies; some institutions prefer to focus on small currencies and are good at currency rotation.
Secondly, from the perspective of the upper limit of market capacity, arbitrage strategy is the highest capacity type of stable income strategy in the market, and its capacity depends on the overall liquidity of the market; roughly estimated that the current overall arbitrage capacity exceeds 10 billion. However, this capacity is not fixed, but forms a dynamic balance with liquidity growth, strategy iteration, and market maturity. In particular, with the rapid growth of crypto derivatives platforms, the entire arbitrage space will grow.
Although there is competition among institutions, due to subtle differences in strategies, different currencies, and different technical understandings, the yield will not be significantly lowered at the current capacity.
4.2 Investor Adaptation
As long as there is a mature risk control system, the arbitrage strategy usually has very little risk and rarely has a drawdown. For investors, the main cost is the opportunity cost of relative returns: in a relatively sluggish market, the arbitrage strategy may have a long-term low return; when the market is good, the explosiveness of returns is usually not as good as that of trend strategies. Therefore, the arbitrage strategy is relatively more suitable for conservative investors.
In terms of advantages, low volatility and low drawdown make it a safe haven for funds in a bear market and more favored by risk-averse and stable funds, such as family offices, insurance funds, mutual funds, and high-net-worth individual wealth allocation.
In terms of disadvantages, the upper limit of returns is not as good as that of trend strategies, and the annualized return of arbitrage strategies ranges from 15% to 50%; it is lower than the upper limit of returns of long strategies/trend strategies (theoretically, it can be 1 to several times).
For ordinary retail investors, personal arbitrage is an investment with low returns + high learning costs and a poor risk-return ratio. It is recommended to participate indirectly through institutional asset management products.
Funding rate arbitrage is the certain return in the crypto market, but the gap between retail investors and institutions is not in cognition, but in the fact that the disadvantages of technology, cost and risk control are too obvious. Instead of blindly imitating, it is better to choose transparent and compliant institutional arbitrage products and use them as the ballast stone of asset allocation.
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Disclaimer
This document is for internal reference only and is based on 4 Alpha Groups independent research, analysis and interpretation of available data. The information contained in this document is not investment advice and does not constitute an offer or invitation to buy, sell or subscribe for any financial instrument, security or investment product to residents of the Hong Kong Special Administrative Region, the United States, Singapore or other countries or regions where such offers are prohibited. Readers should conduct their own due diligence and seek professional advice before contacting us or making any investment decision.
