Funding rates in trading

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Whether in forex, perpetual futures, or traditional futures, holding a position over time comes with financing costs.

© somchaisom, Yevhen/stock.adobe.com; Photo illustration Encyclopædia Britannica, Inc.

As the saying goes, “Time is money.” In financial markets, that idea is applied quite literally. Whether you’re holding a foreign exchange (forex) position overnight, carrying a traditional futures contract, or trading cryptocurrency perpetual futures, someone bears the cost of keeping that position open through time. Funding rates and other financing costs are how markets account for that cost.

Although funding rates have gained attention because of crypto perpetual futures (perps), the underlying concept has been part of forex and futures markets for decades. Even if you’re not actively trading, funding rates can provide valuable clues about market sentiment, demand for leverage, and the balance between buyers and sellers.

A funding rate is the cost—or benefit—of carrying a position over time. How that cost is calculated and who ultimately pays it depends on the market. 

Forex, perps, and traditional futures share a common thread: the cost of carrying a position over time. But each market has unique twists on how funding rates are expressed and utilized.

Foreign exchange trading always involves a currency pair—for example, the U.S. dollar versus the Japanese yen (USD/JPY). Because every forex trade involves buying one currency and selling another, traders who hold positions overnight are exposed to the interest rate differential between the two currencies. Funding rates therefore appear as swap rates or rollover rates, making forex the most explicit of the three markets.

If you’re long a currency with a higher interest rate than the one you’re shorting, you receive a positive swap. Conversely, if you’re long a currency with a lower interest rate than the one you’re shorting, you pay swap charges. These adjustments are typically applied daily at 5 p.m. Eastern time, when positions roll over to the next trading day.

Forex funding rates are relatively stable and predictable because they’re based on central bank interest rates, which change infrequently. However, funding rates can vary between brokers. For so-called carry traders, who try to profit from interest rate differentials, funding rates aren’t just costs—they’re the entire strategy.

Perpetual futures—popularized by cryptocurrencies such as Bitcoin and Ether—differ from traditional futures in one key way: perps have no expiration date. That allows traders to hold positions indefinitely, but also creates a potential problem: Without an expiration forcing convergence with spot prices (see figure 1), perpetual futures could drift significantly from underlying asset values.

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Figure 1: STEADY AS IT GOES. In a typical basis trade, the investor sells a futures contract and buys the corresponding bond, aiming to profit as the gap between the two prices narrows over time.

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Funding rates are designed to address that problem. Exchanges calculate funding rates typically every eight hours based on the difference between the perpetual contract price and the spot price, plus an interest rate component. The formula varies by exchange, but generally includes a premium index measuring how much the perpetual trades above or below spot.

In crypto markets, funding rates can be extremely volatile. During bull markets, traders often crowd into long positions, driving funding rates higher. During bear markets, the opposite may occur, with funding flowing from shorts to longs. Because funding rates reflect the balance between bullish and bearish positioning, traders often watch them as a gauge of market sentiment as well as trading costs.

Traditional futures are standardized contracts based on commodities such as crude oil and corn or financial benchmarks such as stock indexes and interest rates. Unlike perpetual futures, they have fixed expiration dates.

Storing 100,000 barrels of crude oil or 100,000 bushels of corn costs money. That’s one way traditional futures contracts differ from perpetual futures in how financing costs are handled.

Traditional futures don’t require explicit funding payments between traders. Instead, financing costs are embedded in the contract’s pricing, and convergence occurs naturally as the contract approaches expiration.

The basis, or the difference between futures and spot prices, should reflect carrying costs. A futures contract trading above spot (contango) generally reflects the cost of carrying the underlying asset over time. A contract trading below spot (backwardation) often reflects strong demand for immediate delivery or other market forces that outweigh those carrying costs (see figure 2).

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Figure 2: CONTANGO AND BACKWARDATION. Price curves are shaped by market expectations.

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For financial futures such as the E-mini S&P 500 futures or U.S. Treasury futures, the same principle applies, although the carrying costs differ. Instead of storage costs, traders weigh financing costs against benefits such as dividends or interest income that would be earned by holding the underlying asset. In all cases, those carrying costs are reflected in the relationship between futures and spot prices rather than through explicit funding payments. 

Every market has to account for the passage of time. What changes is where the cost shows up. In forex, it’s reflected in overnight rollover. In perpetual futures, it’s an explicit funding payment between longs and shorts. In traditional futures, it’s embedded in the relationship between futures and spot prices.

Those costs may seem small, but they can compound over time, particularly in leveraged positions. Knowing how funding costs are calculated can help you understand how they affect returns. Markets may differ in how they account for financing costs, but none of them escapes the economics of time.