Perpetual contracts are among the most traded derivatives in the cryptocurrency market, with daily trading volumes reaching billions of dollars. While these instruments offer significant profit potential, they also involve leverage, which carries risks—especially when the market moves against your position. However, there is a relatively safer way to earn consistent returns while maintaining market neutrality.
This approach doesn’t eliminate risk entirely, as leverage is still involved, but it allows you to generate passive income from widely traded derivatives. More importantly, it enables you to act as a system participant, largely insulating you from market volatility.
In this guide, we explore actionable strategies for funding rate arbitrage, including one method that achieved an impressive 32% APY in practice. Note that these are advanced strategies and may not be suitable for everyone. Proceed with caution.
Understanding Perpetual Contracts and Funding Rates
Skip this section if you're already familiar with these concepts.
A perpetual contract is a derivative product that allows traders to speculate on the price of an underlying asset without holding the asset itself. Users can open long (bullish) or short (bearish) positions using leverage.
Since it's a derivative, the price of a perpetual contract—known as the mark price—may differ from the spot price of the underlying asset (the index price). To keep these two prices aligned, exchanges use a mechanism called funding rate payments.
Here’s how it works:
At regular intervals (usually every 8 hours), the exchange calculates the difference between the time-weighted average price (TWAP) of the mark price and the TWAP of the index price. If the difference is positive (funding rate > 0), it indicates excessive long positions on the platform. In this case, long position holders pay a funding fee to short position holders.
Conversely, if the difference is negative (funding rate < 0), short positions pay funding fees to long positions.
Summary:
- When mark price > index price: Longs pay shorts
- When mark price < index price: Shorts pay longs
What Influences Funding Rate Direction?
Two main factors affect the direction of funding rates:
- Overall market sentiment: If the market is bullish on an asset, the funding rate is often positive due to more long positions. In bearish conditions, it tends to be negative.
- Exchange characteristics: The design of the trading platform can also influence funding rates. For example, exchanges using automated market maker (AMM) models may exhibit different funding rate behaviors than order book-based exchanges.
What Is a Market-Neutral Strategy?
A market-neutral strategy aims to profit from both rising and falling prices while avoiding exposure to broad market risk. In the context of funding rate arbitrage, this means constructing positions where gains and losses offset each other, allowing the trader to profit primarily from funding fees.
Strategy 1: Perpetual Market + Spot Market Hedge
The simplest way to achieve market neutrality is to open a position in the perpetual market that earns funding fees while hedging with an opposite position in the spot market.
For example, if the funding rate is negative, you can open a long position on the perpetual market and an equivalent short position on a margin trading platform like dYdX or through a lending protocol like Aave.
If the funding rate is positive, open a short perpetual position and buy the underlying asset on a spot exchange like Uniswap.
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Considerations:
- Account for trading fees, borrowing costs, and gas fees.
- Ensure the hedge is properly sized to maintain neutrality.
Strategy 2: Two Perpetual Markets with Opposite Funding Rates
Some platforms consistently exhibit positive or negative funding rates due to their mechanisms. You can exploit this by taking opposite positions on two different exchanges.
For instance, if Exchange A has a negative funding rate for ETH, and Exchange B has a positive rate, you can open a long position on Exchange A and a short position on Exchange B with the same notional value.
This allows you to earn funding fees from both platforms simultaneously.
Example:
- Long on Exchange A: earns funding when rate is negative
- Short on Exchange B: earns funding when rate is positive
With consistent rates, this can yield high annualized returns.
Strategy 3: Perpetual Market + Quarterly Futures Hedge
If a perpetual market has a persistent funding rate direction, you can open a position to collect funding fees and hedge with an opposite position in the quarterly futures market for the same asset.
This is useful when the perpetual funding rate is stable and predictable.
When to close the position?
- When the funding rate direction changes consistently
- When the futures contract approaches expiration
Currently, this strategy is more feasible on centralized exchanges due to greater futures market availability.
Strategy 4: Perpetual Markets + DeFi Yield Combos
For more advanced users, combining perpetual positions with DeFi protocols can unlock additional yield sources.
For example:
- Open a long perpetual position on a platform with negative funding rates.
- Hedge with a short position on Synthetix using an inverse asset like iETH.
- Stake the synthetic asset to earn additional token rewards.
This way, you earn:
- Funding fees from the perpetual position
- Trading rebates or incentives
- Staking rewards from the DeFi protocol
Frequently Asked Questions
What is a funding rate?
A funding rate is a periodic payment between long and short traders designed to keep the perpetual contract price aligned with the spot price.
Is funding rate arbitrage risk-free?
No. While market-neutral, it still involves leverage, liquidation risk, and execution costs.
How often are funding rates paid?
Most platforms settle funding every 8 hours, but intervals can vary.
Can I use this strategy with low capital?
Yes, but smaller positions may be more affected by fees and slippage.
What are the main risks?
Liquidation, funding rate reversal, platform risk, and impermanent hedge mismatch.
Do I need to monitor positions constantly?
Not necessarily, but regular checks are advised to ensure rates remain favorable and hedges are effective.
Conclusion
Funding rate arbitrage offers a compelling way to earn yields in crypto markets without taking directional risk. Whether you use a simple perpetual-spot hedge or a multi-platform strategy, understanding funding mechanics and market dynamics is key.
Remember that these strategies depend on specific market conditions and are not always profitable. Always assess risks, costs, and platform reliability before proceeding.