In the crypto markets, traders are usually bullish, or at least the majority of retail investors are. This causes an interesting phenomenon as it incentives arbitrage desks and whales to sell futures contracts while simultaneously buying on regular spot exchanges.
The above chart shows the incredible 240% gain accumulated in 2021 as crypto reached a $2.58 trillion total capitalization on May 11. The 53% correction that followed over the next week led to a $1.3 trillion bottom, decimating $32 billion of futures open interest.
Perpetual futures automatically rebalance daily
Unlike regular monthly contracts, perpetual futures prices are very similar to those at regular spot exchanges. This makes retail traders' lives a lot easier as they no longer need to calculate the futures premium or manually roll over positions near expiry.
The funding rate allows this magic to occur, and it is charged from longs (buyers) when they are demanding more leverage. However, when the situation is inverted and shorts (sellers) are over-leveraged, the funding rate goes negative, and they become the ones paying the fee.
Notice how AAVE presented a positive funding rate throughout most of the last three months, apart from a couple of single 8-hour instances. The typical situation involves leverage longs paying the fee, and it oscillates from 0% to 0.30% per 8-hour period, which is equivalent to 6.5% per week.
On May 19, as cryptocurrency markets collapsed, AAVE's futures open interest dropped from $200 to $82 million as longs either closed their positions on stop orders or got forcefully liquidated.
After a couple of days trying to stabilize, the perpetual contracts 8-hour funding rate now stands at negative 0.10%, equivalent to 2.1% per week. In this situation, shorts (sellers) pay the fee, creating an incentive for buyers.
A similar pattern emerged on Polygon (MATIC), which lost 62% on May 19 after marking a $2.70 all-time high on the previous day.
There have been some 8-hour periods of negative 0.20% and lower funding rates in MATIC's case, equivalent to 4.3% per week. While this rate oscillates enormously, it creates pressure for short sellers to close their positions as it reduces their margins.
The opportunity is usually short-lived
A negative funding rate creates a safety net for buyers as there are incentives in place to gather strength and try to squeeze the short-sellers.
This is the reason why some analysts refer to the negative funding rate as a buy indicator. However, as soon as shorts close their positions, the situation tends to balance itself, and the funding rate is neutralized.
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