What is Bitcoin funding rate and why does it matter

Perpetual futures contracts are built on the same principles as traditional futures contracts. The key distinction is that crypto exchanges such as Binance and Bitfinex offer perpetual contracts, allowing traders to hold positions without an expiry date. This eliminates the need to worry about settling the contract on a specific date.

Since perpetual futures contracts don’t have expiry dates, some exchanges employ a method to ensure that future prices and index prices converge at regular intervals. This method is known as the funding rate. Based on open positions, traders either pay or receive funding.

As mentioned earlier, perpetual contracts have no expiration date or settlement, allowing traders to hold positions indefinitely. This makes them unique derivative offerings for Bitcoin and other cryptocurrencies.

Traders opt for perpetual contracts to speculate on whether the price of Bitcoin will rise or fall in the future. Those who hold "long" positions expect the price to surge in the future, while those with "short" positions anticipate that the price will decrease in the future.

In this context, when traders take either long or short positions, they can influence the price of the perpetual contract, causing it to deviate from the spot price. The funding rate mechanism ensures that the perpetual contract price does not diverge significantly from the spot price.

For instance, if many traders open long positions and buy a bulk of Bitcoin perpetual contracts, the prices of these contracts can surpass the spot price of Bitcoin. If this happens, the traders who went long would pay the funding rate to those who went short, to keep their positions open.

The further the perpetual contract price deviates from the spot price, the higher the funding payments they have to make to the shorting traders. This incentivization system is designed to align traders' positions in a way that expects the perpetual contract price and spot price to converge or be relatively close to each other over time.

Bitcoin funding rate is made up of regular payments between traders and the same prevents a lasting divergence in the price of both perpetual contract markets and spot prices. Different exchanges readjust the funding rate several times a day. For example, Binance Futures calculate the funding rate of cryptocurrencies every eight hours.

A positive Bitcoin funding rate indicates that more traders are taking long positions and expect Bitcoin’s price to rise in the future. Meanwhile, negative funding rates suggest that more traders are taking short positions and have a bearish outlook.

It is important to stay updated on this metric because a positive or negative funding rate often precedes Bitcoin’s price movements. In simple terms, if Bitcoin’s funding rate is negative, it means that most market participants expect Bitcoin’s price to fall in the future. The same could force others to dispose of their Bitcoin holdings, leading to a fall in Bitcoin’s price. Conversely, a positive funding rate could spur buying in the market, which could send Bitcoin’s price upwards on the chart. Another thing to note here is that extremely negative and positive funding rates can sometimes act as a precursor to market reversals.

As highlighted above, the Bitcoin funding rate can be a powerful metric to determine Bitcoin’s future price. However, it must be used in conjunction with other metrics to accurately predict market direction. Therefore, investors must it at their own discretion.