What is Funding Rate Arbitrage?

What is Funding Rate Arbitrage?

Funding rate arbitrage can be divided into two types:

1.Funding rate arbitrage between spot and perpetual：

Funding rate arbitrage between spot and perpetual contracts refers to simultaneously executing two trades in opposite directions, with equal quantities and offsetting profits and losses, in both spot and perpetual contracts. The goal is to earn funding fee income from perpetual contract trading.
When the funding rate is positive, buying spot and shorting an equivalent position in perpetual contracts generates stable funding fee income. This type of arbitrage is also known as positive arbitrage.
When the funding rate is negative, selling borrowed coins on spot with leverage and going long in perpetual contracts with an equivalent leveraged position earns stable funding fee income. It's important to note that borrowing coins on spot incurs interest. Generally, if the funding fee can cover the interest from spot leverage, it is worthwhile to engage in this arbitrage.

For example: Assuming the current BTC price is 20,000 USDT and the funding rate is 0.03%, let's explore funding rate arbitrage using 4,000 USDT with 1x leverage.

1.Buy 2,000 USDT worth of BTC spot and short 2,000 USDT worth of BTC perpetual contract.
2.Assuming equal funding rates, every 8 hours, you will receive 2,000 USDT * 0.03% = 0.60 USDT.
3.Collecting 0.60 USDT every 8 hours, you would receive 1.80 USDT per day. With an annualized return calculation of 1.80 * 365 / 2,000 = 32.95%.

2.Different Funding Rates across Exchanges：

Arbitrage of different funding rates among different exchanges is another trading strategy that takes advantage of the disparity in funding rates for the same cryptocurrency perpetual contracts between exchanges. It involves combining long positions with low funding rates from one exchange with short positions from another exchange with higher funding rates to generate profits. Funding rates are periodic payments between long and short traders to ensure that the perpetual contract price remains close to the underlying asset price.

For example,Let's say John notices that Exchange A has a higher funding rate of 0.04% for Bitcoin perpetual futures contracts, while Exchange B has a lower funding rate of 0.01%. John buys one Bitcoin perpetual futures contract on Exchange B at a price of $60,000 per Bitcoin and simultaneously sells one Bitcoin perpetual futures contract on Exchange A at the same price of $60,000 per Bitcoin. If the funding rates on both exchanges remain unchanged until the funding settlement, John closes the positions simultaneously on both exchanges, assuming the price on both exchanges is $61,000 per Bitcoin. This results in a profit of $18.3 ($61,000 * (0.04% - 0.01%)) from the funding rate difference between the two exchanges. It's important to note that funding rate arbitrage requires considering factors such as transaction fees and market depth.

Notes on Funding Rate Arbitrage:

1.Lower leverage to avoid liquidation. As perpetual contracts prices move in tandem with spot price actions, there is lower risks or even no risks in funding rate arbitrage. However, users should be still aware of liquidation risks caused by large price fluctuations.

2.Do market research and be cautious about token selection. To arbitrage from funding fees, users need to make their own market research on the assets to buy and their funding rates so as to choose the right token with a higher funding rate that lasts for a long time.

3.Invest properly to reduce trading risks. Slippage may occur if massive investments are plunged into a small-cap token with a limited market depth.

4.Do not change investment assets and adjust positions frequently. Frequently adjusting positions and changing investment assets for hedging will make profits earned fail to cover transaction costs.

In summary, funding rate arbitrage can provide stable income, but it carries risks. In extreme situations, when prices spike in either direction, there is a risk of liquidation for the other side of the position. Therefore, when engaging in funding rate arbitrage, it is important to consider how to control position size to avoid liquidation risks, trading fees, market depth, and other factors.