Funding rates: A beginners guide
So, get this: you’ve read our litepaper, laughed at a couple of our memes, but perhaps still haven’t fully grasped the concept of funding rates, or the gap Juiced is trying to fill within the Solana ecosystem. Well, fret not, for this is the first of many educational articles, that will help our users understand Juiced and how it works!
How do futures work in tradfi?
Back in normie world, traditional futures contracts are used primarily to trade physical products — think coffee beans, crude oil, orange juice, or even live cattle (yes live cattle futures are a thing). Futures contracts are agreements to buy or sell a product at a future date.
These futures contracts mostly expire and settle on a monthly or quarterly basis. Since buying an asset via a futures contract means you could take delivery of that asset (if you let the contract ‘expire’), the price of the future will normally converge with the price of the underlying asset aka ‘the spot price’ as the expiry date approaches. Don’t ever try this at home though by holding a futures contract which expires. Having someone turn up at your house at 6 in the morning with 50,000 barrels of oil isn’t fun.
What about crypto markets?
Here, perpetual futures or perps are somewhat different. They never expire. You can buy as many perpetual futures as you like, you won’t ever take delivery of the underlying cryptocurrency. Therefore, there needs to be some other mechanism to ensure the perpetual future trades as close to the spot price as possible. Here’s where things get interesting…
The exchanges use a mechanism called funding, a payment between those who have gone long on the perp and those who have gone short, to ensure that the perpetual prices converge to spot. Exchanges will track the spread between the spot prices and the perpetuals, and use this to determine the funding rate.
The payment depends on whether the spread between futures and spot is positive (perpetuals above spot) or negative (perpetuals below spot):
- Positive spread: Traders who are long pay funding to traders who are short
A positive spread indicates that there are more long positioned traders, willing to pay funding to short traders.
- Negative spread: Traders who are short pay funding to traders who are long
Negative funding rates indicate that there are more short positioned traders, willing to pay funding to long traders.
The size of the spread determines the size of the payments. A larger spread means a larger payment, and more incentives for traders to collect funding and push perpetuals closer to spot. The most common trade that takes advantage of funding is called funding rate arbitrage: Traders will sell (buy) perpetuals to collect funding payments to shorts (longs), while buying (selling) the spot coin to hedge the coin risk they take.
Essentially, funding rates are designed to encourage traders to take positions that keep perpetual contract prices line in with spot markets. Here’s where Juiced comes into play, by automatising this funding rate arbitrage, traders can skip the constant monitoring required for this basis yield strategy. Solana’s sub second block times will enable a seamless movement of capital from one location to another quickly and robustly, preventing liquidation and establishing a risk free way of farming these funding rates in decentralized exchanges such as Mango Markets.
Hopefully, things will be a little bit clearer after this article, and if it still isn’t the case, feel free to ask around our discord! There’s plenty of info in our litepaper, in case you haven’t checked it out. Stay tuned, for we’ve got many more exciting things coming!