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Funding Payment

What is Funding?

To keep the prices closer to the underlying reference index price, a funding mechanism is used to incentivize traders.
Every hour, traders with open long or short positions will pay each other a funding payment, depending on market conditions. If the contract price is above the spot price, longs will pay shorts. If the contract price is below the spot price, shorts will pay longs. This incentivizes traders to take the unpopular side of the market.
The funding rate is calculated based on the index price (the price of the spot or reference price) and mark price (market price) for the perpetual. When the rate is positive (perpetual trades at a premium relative to the index), long traders will make payments to short traders. While shorts make payments to longs when the rate is negative (perpetual trades at a discount relative to the index).
This mechanism ensures that both parties are incentivized to add/close positions and thus bring the perpetual price closer to the index price.
In an order book setting since a contract will always have two counterparties, the payment is always exchanged between them. Traders make or receive payments in proportion to the size of their market position.
In the case of a VMM structure, since any party long or short can open a trade, the counterparty is always the protocol. In this case, the total long positions and total short positions need not be equal and will be skewed in the direction of the price. This will impose risk on the protocol or insurance fund to pay/receive the balance amount. To avoid this fluctuation and the risk to the insurance fund a different mechanism is used.
Funding payments will always be exchanged between longs and shorts on the platform irrespective of the skew. Protocol won’t be a participant in this mechanism. Therefore longs and shorts will have a separate funding rate based on the skew in open positions and total funding payment to be exchanged.
In an extreme case where there are no longs or shorts open, funding rate will be 0% and no funding payments will be exchanged.

What is Funding Rate?

Since perpetual futures do not have defined end dates, a price-anchoring method called a “funding rate” is established. It provides regular payments between buyers and sellers. The funding rate balances short and long positions by incentivising a market balance. It’s like a rebate or fee to keep the market balanced.
The funding rate mechanism helps ensure the perpetual derivative contract price is close to the spot price. Exchanges use an oscillating price marker to determine if the longs or shorts need to pay fees or receive rebates. The funding rate is positive when the perpetual derivative price is above the spot price.
In general, when a perpetual futures contract is trading on a premium (higher than the spot markets), long positions have to pay shorts due to a positive funding rate. Such a situation is expected to drive the price down, as longs close their positions and new shorts are opened.

How is Funding Rate Calculated?

The Funding rate is calculated every hour using following formulas
FundingRate=((TWAPperpetual−TWAPindex)/TWAPindex)/24FundingRate = ((TWAP_{perpetual} - TWAP_{index})/TWAP_{index})/24
FundingPayment(Payer)=PositionSize∗FundingRateFundingPayment(Payer) = PositionSize * FundingRate
FundingPayment(Receiver)=(∑FundingPayment(Payer)/∑PositionSize(Receiver))∗PositionSizeFundingPayment(Receiver) = (\sum FundingPayment(Payer)/ \sum PositionSize(Receiver))*PositionSize
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