Funding Rate

Funding rate helps keep the price of derivatives close to its index price.

Funding rates are periodic payments between traders that go long, and traders that go short. Funding intervals for perpetual markets on Carbon is every minute.

Carbon's funding rate can be defined with this formula:

FundingRate=PremiumRate+BorrowRateFundingRate = PremiumRate + BorrowRate

Why are Funding Rates Necessary?

Futures contracts have an expiry date which settles at the spot price upon expiry. This helps to pull the price of futures contract to the spot price, especially as it approaches settlement date.

However, perpetual contracts do not have an expiry date. Thus funding rate was created to peg the perp price to the index price.

Without funding rate, the price of the perp can raise or fall to any level without repercussions and becomes unreliable as a trading instrument as it is not able to mimic the index price.

Here's an example of how funding rate works. When a perp is priced higher than the index, traders that go long pay traders that go short (aka longs pay shorts). The higher the deviation, the higher the funding rate. This component of funding rate is also referred to as the premium rate.

This achieves two things:

  1. It encourages more shorts to come in to earn the funding fee, adding sell pressure.

  2. It encourages existing longs to close their position to stop paying the high funding fee, adding sell pressure.

Carbon's funding rate is also affected by an additional borrow rate if the perp market has a perpetual pool linked to it, else the borrow rate is 0.

Premium Rate

The premium rate is calculated from the difference between the perpetual contract's mark price and the index price it is tracking.

This is given by:

Premium Rate = TWA((MarkPrice - IndexPrice) / IndexPrice) / 86400s x FundingIntervalSecs)

The TWA is the time weighted average across the current funding interval, and is sampled every block.

The premium rate is a mechanism to keep the price of perpetual contracts as close to the index price as possible.

When the price of the perpetual contract is above the index price, the funding rate is positive, and long positions pay short positions. When the price of the perpetual contract is below the index price, the funding rate is negative, and short positions pay long positions.

The reasoning for this is that when the price of the perpetual contract is higher than the index, then in order to strengthen demand for shorts and subsequently encourage the price to fall towards the index, shorts are paid funding by longs (positive funding). This has the effect of decreasing demand for longs and increasing demand for shorts until the price reaches the price of the index.

Conversely, when the price of the perpetual contract is lower than the index, in order to strengthen demand for longs and subsequently encourage the price to increase towards the index, longs are paid funding by shorts (negative funding). This has the effect of decreasing demand for shorts and increasing demand for longs until the price approaches the index again.

Borrow Rate

Certain Demex markets that are backed by perpetual liquidity pools have an additional borrow rate component. This borrow rate is essentially a fee charged to traders for temporarily removing liquidity in these pools when they trade against the pool and hold an open position.

The borrow rate for a market is given by:

BorrowRate=BBRƗMVMƗminā”(MU,1)ƗMUSƗPDBorrowRate = BBR \times MVM \times \min(\text{MU}, 1) \times MUS \times PD

Where:

  • BBR = Base Borrow Rate

  • MVM = Market Volatility Multiplier

  • MU = Market Utilization

  • MUS = Market Utilization Scale

  • PD = Pool Direction

The following section goes into the details for each variable.

Base Borrow Rate

This is the base rate that is being charged per hour by the liquidity pool that is backing the market.

Market Volatility Multiplier

This is a static multiplier specific to the market to help manage market risk. For example, if a perpetual pool is backing multiple markets, more volatile markets can still share the pool by having a higher Market Volatility Multiplier.

This allows LPs to be compensated for the additional market risk they take for that specific market without having to fragment liquidity across multiple pools.

Market Utilization

This is the pool liquidity currently used by the market over the maximum liquidity that can be used.

This is calculated as the open position of the pool for the market divided by the pool's liquidity plus urealized PnL.

Note that the open position of the pool is also the nett sum of trades done by users that have matched against the pool.

Market Utilization Scale

This is a multiplier that scale from 1 to 10, which increases linearly over 6 hours, for as long as the 6hr time-weighted Market Utilization remains above the target utilization rate, and vice versa.

This means that a high Market Utilization sustained over a period of time effects a Borrow Rate that scales linearly higher.

Pool Direction

Either:

  • -1 if the pool is long, or

  • 1 if the pool is short.

This means that the Borrow Rate will always be in favor of the pools' current position, incentivizing traders to take the same position of the pool. In other words, this encourages traders to take over the pool's position and decreases the market risk on liquidity providers.

Borrow Rate Calculation Example

Given these variables for a particular perpetual market

  • Base Borrow Fee is 2bps

  • Market Utilization is 50%

  • Market Volatility Multiplier is 1

  • Market Utilization Scale is 1

  • Pool is short

Then the Borrow Rate for that perp market is 2/100 x 50% x 1 x 1 = 0.01% per hour.

If the Market Utilization then becomes 100% and remains that way for 6 hours, the Market Utilization Scale becomes 10, and the Borrow Rate per hour becomes 0.2% (2/100 * 100% * 1 * 10).

This mechanism is designed to incentivize traders / funding arbitrageurs to trade against the current market trend, thereby helping to stabilize the market and skew, while disincentivizing traders from piling into the popular trade and profiting from large market swings in the right direction.

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