Funding Rate of Digital Assets: How to Avoid Being Misled

Since the "Digital Sleeping Beauty," Bitcoin, woke up about two months after its third halving in mid-May 2020, we have read a lot about the "Funding rate" of digital assets futures - from good to completely misleading reports.

During strong market moves or periods of high volatility, the price of the perpetual swap can differ more than during quiet/low volatility periods, leading to a higher funding rate in order to reduce/close the gap between the perpetual swap and the spot price.

Let's have a look at an example of the funding rate.

The more the spot price moves, the more the funding rate increases and vice versa, but the price always leads the funding rate, not the other way around.

The higher the funding rate, the larger the divergence will be between the perpetual swap and the spot price, which confirms strong interest from investors to either buy or sell the underlying crypto.

The funding rate can be seen as true confirmation of strong interest to buy or sell the related instrument: A high positive funding rate confirms the buying interest, whereas a high negative funding rate confirms the selling pressure, as was the case mid-March 2020.

A diminishing funding rate from the highs means less interest from investors, but it doesn't mean the price of the underlying asset is about to reverse, meaning quieter movements in the underlying asset.

Astute traders can use the funding rate as an indicator to adjust any potential leverage on a position in two ways.

An increasing funding rate means more confirmation of a movement, either up or down according to the sign of the funding rate.

Investors can decide to either leverage their position more - as the move of the underlying crypto is strong and expected to last from a few hours to a few days - to take advantage of the move, or if they are already leveraged during normal moves - i.e., confirmed by a low funding rate - they can reduce their usual leverage in order to keep risk exposure more or less stable over time.