Perptual Futures and funding rate: the balancing mechanism of the crypto market

1. Basic Concepts of Perpetual Futures and Funding Rate

1.1 Characteristics of Perptual Futures

Perptual Futures are a special derivative in the crypto market, with the following main characteristics:

• No delivery date, allowing for long-term positions
• Maintain consistency with spot prices through the funding rate mechanism
• Adopt a dual price mechanism: marked price and real-time transaction price

1.2 The principle of funding rate

The funding rate is a key mechanism used to adjust the long and short forces in Perptual Futures:

• Composed of the premium part and the fixed part
• When the contract price is higher than the spot price, the funding rate is positive, and longs pay the fee.
• When the contract price is below the spot price, the funding rate is negative, and the shorts pay the fees.
• Usually settled every 8 hours

1.3 A Simple Explanation of the Funding Rate Mechanism

The funding rate mechanism can be compared to the adjustment mechanism of the rental market:

• The bull is equivalent to the tenant, while the bear is equivalent to the landlord.
• When there are too many tenants, additional fees must be paid to the landlord, and vice versa.
• Essentially a mechanism for market dynamic equilibrium adjustment.

2. Funding Rate Arbitrage Strategy

2.1 Arbitrage Principle

The core of funding rate arbitrage is:

• By hedging spot and contract positions, lock in funding rate returns.
• Avoid price fluctuation risks
• Belonging to delta neutral strategy

2.2 Three Main Arbitrage Methods

1. Single currency single exchange arbitrage

   • Shorting contracts and longing spot on the same exchange

2. Single-Currency Arbitrage Across Exchanges

   • Long and short Perptual Futures on different exchanges.

3. Multi-Currency Arbitrage

   • Arbitrage using the funding rate differences of highly correlated cryptocurrencies

The difficulty and technical requirements of these methods increase sequentially, with the first one being the most common in practice.

3. Analysis of Institutional Advantages

3.1 Opportunity Identification

Institutional Advantages:

• Algorithm real-time monitoring of all market data
• Millisecond-level identification of arbitrage opportunities

Retail Investor Disadvantages:

• Rely on manual or third-party tools
• Can only obtain lagging data, coverage is limited.

3.2 Transaction Execution Efficiency

Institutional Advantages:

• High-Frequency Trading System
• Low latency connection
• Bulk Order Capability
• Scale effects reduce costs

Retail disadvantages:

• The manual operation speed is slow
• The transaction cost is relatively high

3.3 Risk Control

Institutional Advantages:

• Systematic Risk Control System
• Millisecond-level response
• Precise position adjustment
• Multi-currency simultaneous processing capability

Retail disadvantages:

• Manual monitoring, slow response
• Limited risk disposal capability
• Difficult to accurately adjust positions

4. Outlook on Arbitrage Strategies and Investor Adaptation

4.1 Differences in Institutional Arbitrage Strategies

• Similar ideas but each has its own characteristics
• The market capacity is large, estimated to exceed 10 billion US dollars.
• Capacity dynamically changes with market development.

4.2 Investor suitability

Arbitrage strategy characteristics:

• Low risk, small drawdown
• Relatively stable returns, but with a lower ceiling.

Suitable for investor types:

• Conservative Investor
• Risk-averse investors
• Institutional investors (such as family offices, insurance funds, etc.)

Advice for ordinary investors:

• The difficulty of personal arbitrage strategies is high, and the risk-reward ratio is not favorable.
• It is recommended to participate indirectly through professional institution products.
• Can serve as a stable component of asset allocation