Why is the funding rate of the perpetual contract negative?

In the scenario of a negative funding rate in perpetual contracts, traders holding long positions pay those holding short positions, potentially increasing trading costs and reducing profitability.

Nov 19, 2024 at 10:03 am

Why is the Funding Rate of the Perpetual Contract Negative?

Perpetual contracts are a popular type of derivative that allows traders to speculate on the price of an underlying asset without having to take physical delivery. The funding rate is a periodic payment that is made between traders on opposite sides of the perpetual contract, and it is designed to ensure that the price of the perpetual contract tracks the price of the underlying asset as closely as possible.

Negative Funding Rate

In some cases, the funding rate of a perpetual contract can become negative. This means that traders who are long on the perpetual contract (i.e., they believe that the price of the underlying asset will increase) are paying traders who are short on the perpetual contract (i.e., they believe that the price of the underlying asset will decrease).

Causes of a Negative Funding Rate

There are a number of factors that can lead to a negative funding rate, including:

• High demand for shorts: If there are more traders who want to short a perpetual contract than there are traders who want to long it, this can lead to a negative funding rate. This is because the traders who are shorting the perpetual contract are willing to pay traders who are longing it in order to get them to take the other side of the trade.
• Low demand for longs: If there are fewer traders who want to long a perpetual contract than there are traders who want to short it, this can also lead to a negative funding rate. This is because the traders who are longing the perpetual contract are willing to pay traders who are shorting it in order to get them to take the other side of the trade.
• Contango market: A contango market is one in which the price of an asset is expected to rise in the future. In this type of market, traders are more willing to short perpetual contracts because they believe that they will be able to profit from the price increase. This can lead to a negative funding rate.
• Backwardation market: A backwardation market is one in which the price of an asset is expected to fall in the future. In this type of market, traders are more willing to long perpetual contracts because they believe that they will be able to profit from the price decrease. This can lead to a positive funding rate.

Impact of a Negative Funding Rate

A negative funding rate can have a number of impacts, including:

• Increased trading costs: A negative funding rate can increase the trading costs for traders who are longing a perpetual contract. This is because they have to pay traders who are shorting the perpetual contract in order to keep their positions open.
• Reduced profitability: A negative funding rate can also reduce the profitability of trading perpetual contracts. This is because the negative funding rate reduces the potential profit that can be made from a trade.
• Increased volatility: A negative funding rate can also increase the volatility of perpetual contracts. This is because it can lead to a feedback loop, in which the negative funding rate attracts more traders to the short side of the contract, which in turn leads to a further negative funding rate.

Conclusion

The funding rate of a perpetual contract is an important factor to consider when trading these instruments. A negative funding rate can have a number of impacts, including increased trading costs, reduced profitability, and increased volatility. Therefore, it is important to understand the causes of a negative funding rate and how it can impact your trading strategy.