Uncovering the secrets of funding rate arbitrage: How do institutions “make money without doing anything”, and why can retail investors “see but not get anything”?
Blockchain editor
Funding rate arbitrage strategy is one of the more stable profit strategies in the crypto market and is favored by institutions. However, for ordinary investors, this strategy is extremely difficult to implement, and it is often "visible but not edible". This article will deeply analyze the basic principles and specific methods of funding rate arbitrage, as well as the core competitiveness of institutions in this field, to help readers fully understand its essence and application.
1. Basic concepts and principles of funding rate: "balance tax" and "red envelope" mechanism in the currency circle
1.1 What is a perpetual contract?
In the financial market, arbitrage opportunities between spot and futures markets are not uncommon, and participants range from large hedge funds to individual investors. However, in the 24-hour non-stop trading environment of the crypto market, a special derivative product, the perpetual contract, was born.
The core difference between perpetual contracts vs. traditional futures contracts:
No delivery date: Perpetual contracts do not have a delivery date, and users can hold positions for a long time with sufficient margin and no liquidation.
Funding rate mechanism: The spot price is anchored by the funding rate, so that the contract price is 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 the position is liquidated, determined by the weighted average price of multiple exchanges to prevent a single platform from manipulating the market.
Real-time transaction price: the actual transaction price in the market, which determines the user's 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
The funding rate is a mechanism used in perpetual contracts to adjust the market's long and short forces. 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 interest rate = basic 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 suppress the over-optimism of the longs.
When the funding rate is negative, on the contrary, the shorts need to pay the fees to the longs to suppress the over-pessimism of the shorts.
Funding rate settlement cycle: Generally, it is settled every 8 hours, that is, users holding contracts in each settlement cycle need to pay or receive the funding rate.
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 rental market:
Tenants (long) = investors who buy perpetual contracts
Landlords (short) = investors who short perpetual contracts
Average price in the area (marked price) = average price in the spot market
Actual rental price (contract real-time price) = market transaction price of perpetual contracts
For example:
If there are too many tenants (longs) and the rent (contract price) is driven up to exceed the market average price (marked price), then the tenant needs to pay a red envelope (funding rate) to the landlord to make the rent fall.
If there are too many landlords (shorts), resulting in the rent being suppressed, then the landlord needs to pay a red envelope to the tenant to make the rent rise.
In essence, the funding rate is a dynamic balance adjustment tax in the market, which is used to punish the party that "destroys the market equilibrium" and reward the party that "corrects the market equilibrium".
2. 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: by hedging spot and contract positions, locking in funding rate income and avoiding price volatility risks. Its basic logic includes:
Rate direction judgment: According to the long and short forces, when the funding rate deviates significantly, there is a large arbitrage space
Risk hedging: offset the price volatility risk through the reverse position of spot and contract, and only earn the funding rate
High-frequency compounding: settlement every 8 hours, the compounding effect is significant
In essence, funding rate arbitrage is a Delta-Neutral Strategy, that is, locking in a specific income factor (funding rate) without taking the price direction risk.
2.2 Three methods of funding rate arbitrage
1) Single currency single exchange arbitrage (most common)
Specific operation steps:
a. Determine the 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.
b. Establish a position: short perpetual contract + long spot
c. Charge rate: Assuming that the spot price of the underlying asset rises, the short contract in the combination will suffer losses, and the gains and losses of the two will offset each other, but the long futures contract needs to pay you funding fees to earn funding fee income.
2) Single currency cross-exchange arbitrage
Specific operation steps:
a. Scan exchange funding rates: Select two exchanges with sufficient liquidity and large differences in funding rates
b. Establish a position: short perpetual contract (A) + long perpetual contract (B)
c. Earn funding fee difference: Earn the difference based on the different funding rates of the exchanges
3) Multi-currency arbitrage
Specific operation steps:
a. Select highly correlated currencies: that is, currencies with highly similar trends, use the differentiation of funding rates, and hedge the direction through position combinations to earn profits.
b. Establish positions: short high-funding-rate currencies (such as BTC) + long low-funding-rate currencies (such as ETH), and adjust positions according to the ratio
c. Earn income: funding rate difference + volatility income
Among the above three methods, the difficulty increases in turn. In actual practice, most of them are the first one. 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 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 income 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 arbitrage method is used, it is necessary to hedge the risk of price fluctuations completely, otherwise the income will be eroded. In addition, the cost needs to be considered: such as handling fees, borrowing costs (if leveraged), slippage, margin occupation, etc. As the overall market matures, the income of simple strategies will decline, and it is necessary to combine algorithm monitoring, cross-platform arbitrage and dynamic position management to make 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 not eat"? What is the reason?
Funding rate arbitrage seems to be simple in logic, but in practice, institutions have established huge advantages with technical barriers, scale effects and systematic wind.
3.1 Opportunity identification latitude: dimensionality reduction strike in speed and breadth
Institutions use algorithms to monitor the funding rate, 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 lagging data and focus on a few mainstream currencies.
3.2 Opportunity capture efficiency: cost gap under technology and transaction volume differences
With the huge advantages of the entire technical system and cost control, the gap in arbitrage income 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 the entire risk control, institutions have a mature system for controlling position risks, and can operate in a timely manner when extreme situations occur. They can selectively reduce positions, replenish insurance, and other means to reduce risks, while retail investors do not respond in a timely manner and have limited means when extreme situations occur. The main differences are as follows:
a. Response speed: The response speed of institutions is at the millisecond level, while that of individuals is at least at the second level. When they are not closely monitored, it is even at the minute or hour level, making it difficult to ensure a rapid response
b. Accuracy of risk control disposal: Institutions can reduce the positions of certain currencies to a reasonable level based on accurate calculations, or choose to replenish margin to a reasonable range, and dynamically adjust to ensure that no risks occur; while individuals lack the ability to accurately calculate and operate, and can basically only choose to close positions at market prices
c. Multi-currency processing: When risks occur and need to be handled, 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 most
4. Prospects of arbitrage strategies and investor adaptation
4.1 Differences in institutional arbitrage strategies and market cap
Most people will have a question: if all institutions adopt arbitrage, can the capacity of this market support it and will it reduce returns? In fact, in terms of the entire logic, there is a clear "similarity" between institutions.
Similarities: The same type of strategy, such as arbitrage, has roughly the same strategic ideas;
Small differences: Each institution has its own strategic preferences and unique advantages. For example, some institutions prefer to do large currencies and dig deep into large currency opportunities; some institutions prefer to do small currencies and are good at currency rotation.
Secondly, from the perspective of the market capacity cap, 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; it is 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, it will bring about the growth of the entire arbitrage space.
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 under 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 opportunity cost is the relative return: in the period of relatively sluggish market transactions, arbitrage strategies may be at low returns for a long time; when the market is good, the explosiveness of returns is usually not as good as that of trend strategies. Therefore, arbitrage strategies are relatively more suitable for conservative investors.
From the advantages, low volatility and low drawdowns, bear markets can become a safe haven for funds, and are more favored by risk-averse and stable funds, such as family offices, insurance funds, mutual funds, and high-net-worth personal wealth allocation.
From the disadvantages, the upper limit of returns is not as good as the trend strategy, and the annualized arbitrage strategy ranges from 15% to 50%; it is lower than the upper limit of returns of long strategiesrend 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 "certainty of returns" in the crypto market, but the gap between retail investors and institutions is not in cognition, but in the obvious disadvantages of "technology, cost and risk control". 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.
