Funding Risk

Funding Risks

Funding rates are a pivotal component of perpetual futures markets, serving as the engine that drives yield generation in basis trading. However, they also introduce a unique set of risks that can significantly affect the profitability and sustainability of a strategy like BasisOS.

Understanding Funding Rates

• Mechanism: Funding rates are periodic payments exchanged between traders holding long and short positions. They are determined by the difference between the perpetual contract’s price (mark price) and the spot price (index price) of the underlying asset. When a contract trades at a premium relative to the spot market, funding is typically positive—meaning long positions pay short positions. Conversely, if the contract trades at a discount, funding becomes negative, and shorts end up paying longs.

• Calculation & Adjustment: The funding rate is recalibrated at regular intervals (commonly every 8 hours) to help realign the perpetual contract’s price with the underlying spot price. This continuous adjustment ensures that the market stays tethered to the spot value, albeit with inherent fluctuations driven by supply, demand, and open interest dynamics.

• Impact on Traders: For a basis trading strategy that relies on securing spot positions with a corresponding short hedge, positive funding rates are crucial. They generate profit by providing a steady income stream from the funding payments. However, if the funding rate turns negative, the cost burden shifts to the short side, potentially eroding profits or even causing losses over time.

The Role of Funding Rates in Basis Trading

• Profitability Dependence: BasisOS’s strategy hinges on the assumption that funding rates will remain positive most of the time. The protocol’s design is centered on capturing these funding fee premiums, whereby long positions consistently pay short positions. A reversal in this dynamic—where shorts end up paying longs—poses a serious threat to the strategy’s profitability.

• Open Interest Dynamics: On platforms such as GMX v2, funding rates are not solely a function of price differences but are also heavily influenced by the imbalance in open interest between long and short positions. A significant shift in open interest can rapidly alter the funding environment, thereby amplifying funding risks. Logarithm Finance addresses this by actively managing open interest and reducing price impact through mathematically verified algorithms, ensuring that the strategy remains effective even as market conditions change.

Empirical Observations and Market Experience

• Mean-Reverting Behavior: Historical data from major decentralized exchanges (DEXs) like Binance and Bybit indicate that funding rates tend to display mean-reverting behavior. This means that while funding rates may occasionally dip into negative territory, they generally revert to a positive baseline. This positive bias is essential for maintaining profitability in a basis trading strategy.

• Open Interest Weighted Funding Rate Index (WFRI): A key metric used to evaluate funding potential is the Open Interest Weighted Funding Rate Index (WFRI). WFRI is calculated by dividing the sum of the product of the average open interest and funding rate for each ticker by the total open interest across all tickers on the exchange. This index provides a comprehensive view of the effective funding environment, reflecting both the magnitude of open interest and the prevailing funding rates.

Platform-Specific Considerations

• GMX v2: GMX v2 employs a unique funding rate calculation mechanism that relies on open interest imbalances rather than the traditional market-to-index price ratio. This means that even when trading occurs against a liquidity pool (instead of matching orders in an order book), funding rates are influenced by shifts in open interest. The distinctive design of GMX v2 often results in a persistent positive funding rate—provided that long positions remain dominant.

• Hyperliquid: Hyperliquid, in contrast, utilizes an order book system similar to centralized exchanges. Its funding rate mechanism is designed to closely mirror those used on major CEX platforms, with funding recalibrated every 8 hours and distributed in smaller increments hourly. However, the liquidity profile and trading dynamics on Hyperliquid differ, which can lead to variations in funding rate behavior, particularly during periods of low trading volume.

• dYdX: On dYdX, funding payments are calculated based on the index price and sampled mid-market prices. The platform’s approach results in hourly adjustments, with funding scaled to have an 8-hour realization period. This method ensures that traders are charged or credited in proportion to their position size, further emphasizing the importance of accurately managing exposure to avoid unfavorable funding conditions.