Funding rate arbitrage

Funding rate arbitrage
Funding rate arbitrage is a trading strategy that involves taking advantage of the difference in funding rates between perpetual futures contracts and spot markets for cryptocurrencies.
Perpetual futures are like traditional futures with one important difference: they don’t have an expiration date. You can hold your position without thinking about maturity date and delivery. That perpetuals don’t expire means that there should be a mechanism ensuring that perpetuals prices won’t diverge from the prices of underlying assets. This is where funding rate enters the play. Funding rate helps perpetual price converge to the price of the underlying asset.
The prices of a perpetual contract and of the underlying asset are called mark and index respectively. If the perpetual is trading at a premium to the index (i.e., perpetual price is higher than the underlying asset price), to hold the perpetual is better than to hold the coin itself. That’s why longs will pay short an amount that corresponds to the divergence of the mark from the index. This is also called a positive funding rate. Conversely, a negative positive rate is something that shorts owe longs. This happens when the mark is trading lower than the index.
Let’s say, ETH price is $1,700 while ETH-PERP is trading at $1,703 currently. The perpetual is trading at a discount the index which means that there is a positive funding rate of 0.176%. ( (1703-1700) / 1700 )
If the dislocation of the mark from index price lasts too long, the arbitrageurs can exploit it by taking opposite positions in the perpetual and the underlying asset. In this example, a trader could short ETH-PERP and buy ETH. The sell pressure on the overvalued (expensive) asset and the buy pressure on the undervalued (cheap) asset will cause the prices to converge. Thus, the trader will earn the funding rate on (almost) the risk-free trade.
Funding rates are determined by the market. If traders are more inclined to be leveraged on the long side, then there will be a demand for buying the perpetual contract. This implies that the mark (perpetual’s price) will trade at a premium to the index (the underlying asset price) which cause the funding rate to be positive. Conversely, the demand to be leveraged short will cause the perpetual to trade at a discount to the underlying asset. Thus, the funding rate will be negative.
One trading strategy that can be built around the concept of funding rates involves shorting the perpetual contract with a positive funding rate and buy the same coin on the spot market. The idea to going long the cheap asset and shorting the expensive one thus pocketing the difference in prices.
Spot markets, on the other hand, involve the buying and selling of actual cryptocurrencies at their current market price.
Funding rate arbitrage takes advantage of situations where the funding rate of a perpetual futures contract is higher or lower than the interest rate of the cryptocurrency in the spot market. Traders can borrow the cryptocurrency in the spot market and use it to open a long or short position in the perpetual futures contract, depending on the funding rate differential. By doing so, they can earn the difference in interest rates between the two markets.
This strategy requires careful monitoring of funding rates and interest rates, as well as close attention to market trends and liquidity. It is a popular strategy among cryptocurrency traders who are looking to profit from short-term price movements and market inefficiencies. However, like all trading strategies, funding rate arbitrage carries risks and may not be suitable for all investors.
Let's say you are a cryptocurrency trader who wants to take advantage of funding rate arbitrage between two different perpetual futures contracts, let's call them Contract A and Contract B.
The funding rate is the fee paid by long and short traders to each other every few hours in order to maintain a balance between long and short positions. If the funding rate is positive, long traders pay short traders, and if the funding rate is negative, short traders pay long traders.
Assume that you notice that Contract A has a positive funding rate of 0.05% per hour, while Contract B has a negative funding rate of -0.02% per hour. This means that long traders on Contract A are paying short traders, while short traders on Contract B are paying long traders.
To take advantage of this arbitrage opportunity, you could do the following:
Borrow funds in cryptocurrency from a lending platform at a low-interest rate.
Use those borrowed funds to go long on Contract A, which has the higher positive funding rate.
At the same time, go short on Contract B, which has the lower negative funding rate.
Every few hours, when the funding rate is paid, you will receive a net payment from the long position on Contract A and pay a smaller payment on the short position on Contract B.
Repeat this process every few hours until the funding rate on Contract A becomes negative or the funding rate on Contract B becomes positive.
By doing this, you can earn a profit from the difference in funding rates between the two contracts. However, it's important to note that funding rate arbitrage can be risky, and it's important to carefully manage your positions to avoid losses.