What’s the Funding Rate for Funding-Rate Markets? How Strips Keeps Rates Aligned.
Who watches the Watchmen, and what’s the funding rate for the markets that track funding rates?
Funding rates are a critical component of perpetual futures contracts. Normal futures have an expiration date which forces them to converge with the underlying price of the asset they track. Since perpetual futures have no expiration, they are kept moored to the asset they track via the funding rate. To learn more about funding rates, please read our explainer here.
Strips makes markets on these funding rates. The Fixed Rate is the rate traded and created on Strips. The Floating Rate is the current funding rate on the referenced exchange.
What stops these two rates from disconnecting? What’s the funding rate for the funding-rate markets?
To keep these Fixed and Floating-Rate markets more closely aligned, we do so via our Funding PnL cash flows.
If you go to Strips.Finance and look at our UI, you’ll notice the rates displayed are annualized ones.
However, if you go to our Funding PnL explainer in our docs, you’ll see a denominator that may confuse you if this is an annual calculation.
So you’re seeing annualized rates on the UI, however the spread between these rates (Funding PnL) is paid out monthly (30 in the denominator represents a month-long duration, if it were being paid out annually you’d expect the denominator to be 365). If you’re receiving a Floating rate of 7% and paying a Fixed rate of 3% on your notional investment, that 4% difference will be fully realized monthly. That means your annualized Funding PnL in this scenario would be 48% (4% x 12).
We do this because the Funding PnL spread being realized on a monthly basis acts as an incentivizing force for market participants to arbitrage out large differences between Fixed and Floating Rates.
For example: in a situation where a Floating Rate was materially higher than its Fixed counterpart and stayed there, market participants would want to go long that market (long means receiving Floating payments, paying Fixed, and being long the Fixed Rate from a spot perspective) because you’d be collecting a large Funding PnL spread. The incentive to go long is much greater when Funding PnL can be realized so quickly. Doing this causes buyers to bid up the Fixed Rate more aggressively and bring the market into equilibrium.
If the Funding PnL was only fully realized on an annual basis, there would be much less motivation for this gap to be closed. What do you think excites arbitragers more: a 4% APR or a 48% one?
For any questions on this or Strips rate-swap markets, please join our Discord.
The information presented here is meant for educational purposes, and is not investment advice. Any past performance, projection, forecast or simulation of results does not necessarily indicate any investment’s future or likely performance. The information and publications are not intended to be and do not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort offered or endorsed by STRIPS Finance.