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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:
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.
The premium rate is calculated from the difference between the perpetual contract's mark price and the index price it is tracking.
Premium Rate = Time Weighted Average of ((mark price - index price) / index price) / no. of settlement intervals
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.
The premium rate is calculated using these 5 components:
- Base Borrow Fee for the pool (in bps)
- Static Market Multiplier (No cap)
- Market utilization Rate (caps at 100%)
- Market Utilization Multiplier (1 to 10)
- Pool's Direction (determines the direction of the funding rate)
Borrow Rate = Base Borrow Fee for the Pool * Static Market Multiplier * the Minimum of 1.0 or Market Utilization Rate * Market Liquidity Usage Multiplier * -1 if the Pool is Long, otherwise 1.
Let's break it down further.
The borrow fee is a static fee in bps that determines the borrow fee incurred at every funding interval. This is a predetermined value that serves as the starting point for the calculation.
This is a static multiplier that can be added to the borrow fee for individual perp markets to help manage risk further. For example, if a perp pool consists of multiple perp markets, riskier or more volatile perp markets can have a higher static market multiplier.
The default is 1x (no additional multiplier).
The utilization rate determines how much of the perpetual pool's liquidity is being utilized, as in taken by another trader to open a position.
- If the utilization rate is less than or equal to 1.0, use the actual utilization rate in your calculation.
- If it's greater than 1.0, just use 1.0 instead. This ensures that the utilization rate doesn't excessively amplify the borrow fee.
The dynamic borrow rate uses a time-weighted average market utilization multiplier which helps to rebalance the pool's exposure to protect the market maker from potential significant losses.
- Market Utilization: The pool's open position in the market plus the unrealized profit and loss in the market, divided by the pool's allocation to that market.
- Time-Weighted Average Market Utilization (TWA Market Utilization): A time-weighted average of the market utilization, currently based on the past 6 hours.
- Multiplier: A calculated factor from 1 to 10, based on the trader's net position against the pool and the TWA Market Utilization.
This creates a multiplier that continuously amplifies the borrow rate a trader pays every funding interval (up to 10x), if the trader is trading with the market trend, and reduces it if the trader is trading against it.
Multiply the result so far by the market's liquidity usage multiplier. This value adjusts the fee based on how the liquidity in the pool is being used.
Finally, modify the total based on whether the pool is in a long or short position:
- If the pool is long (
poolIsLongis true), multiply the result by -1. This essentially negates the fee.
- If the pool is short (
poolIsLongis false), keep the result as it is (effectively multiplying by 1).
When the pool's position is long, borrow rate will be charged on shorts to encourage people to long so that they can close against the pool's sell orders, resulting in the pool's position reducing.
When the pool's position is short, borrow rate will be charged on longs to encourage people to short so that they can close against the pool's buy orders, resulting in the pool's position reducing.
Given these variables in a particular perpetual market:
- Borrow fee is 2bps
- Market utilization rate is 50%
- Static market multiplier is 1x
- TWA market utilization multiplier is 1
- Pool's direction is short
Then the borrow fee per hour for that perp market is 2/100 * 50% * 1 * 1 = 0.01% per hour, pro-rated to the existing funding interval.
If the market utilization is 100% and remains for 6 hours, the TWA market utilization multiplier becomes 10, and the borrow fee per hour becomes 0.2% per hour (2/100 * 100% * 1 * 10), pro-rated to the existing funding interval.
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.