Funding Rate Arbitrage

Funding Rate Arbitrage

Funding Rate Arbitrage | Published Jan 1, 2023

Funding rate arbitrage can produce high yields while remaining delta-neutral, particularly in bullish market conditions.

What isDelta Neutral’?

A position that is delta neutral has no directional bias and therefore little to no possibility of profit or loss. For example, if you buy $100k worth of BTC and short $100k worth of BTC on a perp exchange, you are delta neutral.

If BTC price drops 10%, you’ll profit 10% on your BTC short but lose 10% on your spot position.

If BTC price pumps 10% you’ll make 10% on your BTC spot position, but lose 10% on your short position.

What is Funding Rate?

Funding rate is a mechanism used by derivatives exchanges to peg the price of a derivatives contract to the spot price.

When the market is bullish, leveraged perp prices can trade higher than spot prices (see below) due to the increased demand for leverage.

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When the price of a perpetual contract deviates from the underlying asset price, exchanges adjust the funding rate to encourage long or short positions to pay funds in the opposite direction, bringing the contract price back to the underlying asset price.

During a bullish market trend, the funding rate is usually positive and increases over time, with long positions paying the funding rate to short positions.

Conversely, during a bearish market, the funding rate is usually negative, with short traders paying fees to long traders.

This means when the funding rate is positive, long positions are paying you to short the asset. Obviously, shorting an asset that is in a bullish trend is very risky. So instead we can employ a delta neutral strategy to eliminate directional risk and collect funding fees.

Let’s walk through an example:

Here (https://www.coinglass.com/funding/SOL) we see the current funding rate for SOL on BingX is 0.0709% (bottom right corner).

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Funding on most exchanges, including BingX, is paid out every 8 hours. So we take our 8 hour rate, multiply by 3 to get our daily rate, and multiply by 365 to get our annualized rate.

0.0709% x 3 = 0.2127%

0.2127% x 365 = 77.6%

So the current annualized funding rate is 77.6%, meaning if we short SOL, we will be earning an annualized rate of 77.6% APY on our position.

For easy math, let’s say we short $100k worth of SOL on 1x leverage.

We then want to mitigate directional risk, so we would buy $100k worth of spot SOL.

We are now delta neutral, earning 77.6% APY on our $100k short, or roughly $212 per day.

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Important Note

Funding rates fluctuate over time. In a bull market they can remain elevated for weeks, making these high yields achievable for extended periods of time. However, eventually they normalize back to 0 or even negative if the market shifts bearish.

In total we have deployed $200k in capital to achieve this yield, so our net APY is 77.6% divided by 2, for a net 33.8% APY on the total $200k.

Now instead of leaving our spot SOL position idle, we can earn yield on that too.

We can swap our SOL for a liquid staking derivative (LSD) like jitoSOL, mSOL, or LST.

LST currently yields around 8% in SOL.

So now we have $100k earning 77.6% APY paid in USDT and $100k earning 8% APY in SOL (accrued to the LST token value).

We can further optimize our yield by using 2x leverage to short the perp instead of 1x. So we can use $50k on 2x leverage to short $100k worth of SOL.

In this example we have deploy $50k to earn 77.6% on a $100k position and are still holding 100k spot $LST earning 8% on SOL.

Now instead of earning ~34% APY on $200k, we’re closer to ~44% due to needing less capital ($150k instead of $200k).

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Important Note

Because we are shorting an asset on leverage, the short position will have a liquidation point.

If you short SOL on 2x leverage at $100, your liquidation point will be ~$150. This means if SOL price goes above $150, your short position will be liquidated, leaving you directionally exposed to the market again.

It is extremely important to keep a stop loss below your liquidation point and rebalance your positions if price comes anywhere near your stop loss.

Note that moving in and out of positions while farming funding rate will incur exchange fees and slippage, which means it’s best to not move in and out of positions too frequently if you can avoid it. Ideally, funding rate stays elevated for weeks/months while price does not press towards your stop loss.

Also note that farming funding rate carries risks:

  • liquidation risk
  • centralized exchange risk
  • smart contract risk (if using a liquid staking derivative)
  • risk of funding rate turning negative

Advanced Example: Farming funding rate with $JLP

See our $JLP overview first if you do not understand what $JLP is.

Buy $100k worth of $JLP or deposit $100k into $JLP directly when the pool opens.

JLP currently earns ~100% APY via perp fees on Jupiter, but gives directional exposure to:

  • 34% SOL
  • 10% ETH
  • 6% WBTC
  • 40% USDC
  • 10% USDT

In order to hedge out this directional risk, we can deposit $25k on exchange like BingX or Bybit.

  • $17k on 2x leverage to short $34k worth of SOL
  • $5k on 2x leverage to short $10k worth of ETH
  • $3k on 2x leverage to short $6k worth of BTC

The funding rates across SOL, ETH, and BTC fluctuate regularly, but should net out to anywhere between ~25% and ~75% on our $25k in capital at this point in time given current rates.

End result:

$100k earning 100% APY

$25k earning 25% - 75% APY

Of course, these rates are not sustainable long term and will fluctuate over time. Holding JLP also carries its own risks.

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Important Note

You can use https://www.coinglass.com/ArbitrageList to sort for the best funding rate arbitrage opportunities (make sure to sort by ‘short’). Keep in mind, many of the highest yielding opportunities on the list carry more risk because they are illiquid and the funding rate will likely only stay elevated for a short period of time.

It is best to focus on opprtunities in liquid markets (top 25 to 50 coins by market cap).

Ideally, you want to focus on highly liquid coins that also have liquid staking derivatives like SOL, ETH, AVAX, etc so you can earn yield on the spot positions too.

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