1. Basic Concepts and Principles of Funding Rates: The "Balance Tax" and "Red Packet" Mechanism in the Crypto World

1.1 What is a Perpetual Contract?

In financial markets, arbitrage opportunities between spot and futures markets are not uncommon, with participants ranging from large hedge funds to individual investors. However, in the 24/7 trading environment of the crypto market, a special derivative has emerged—perpetual contracts.

Core Differences Between Perpetual Contracts and Traditional Futures Contracts:

• No Expiration Date: Perpetual contracts do not have an expiration date, allowing users to hold positions long-term as long as their margin is sufficient and they are not liquidated.
• Funding Rate Mechanism: The funding rate anchors the spot price, ensuring that the contract price remains aligned with the spot index price over time.

In terms of pricing mechanism, perpetual contracts use a dual price mechanism:

• Mark Price: Used to calculate liquidation, determined by the weighted average price of spot across multiple exchanges to prevent market manipulation by a single platform.
• Real-Time Transaction Price: The actual trading price in the market, which determines the user's opening cost.

Through the funding rate mechanism, perpetual contracts can maintain long-term market equilibrium without an expiration date.

1.2 What is the Funding Rate?

The funding rate is a mechanism used in perpetual contracts to adjust the market's long and short forces, with the core purpose of keeping the contract price as close to the spot price as possible.

In terms of calculation, the funding rate consists of a premium component and a fixed component, where the premium refers to the degree of deviation between the real-time transaction price of the contract and the spot index price.

• Premium Rate = (Contract Price - Spot Index Price) / Spot Index Price
• Fixed Rate = The base rate set by the exchange

When the funding rate is positive, it indicates that the contract price is higher than the spot price, suggesting a strong bullish market. In this case, the longs must pay the funding rate to the shorts to curb excessive optimism among the longs.

When the funding rate is negative, the opposite is true; the shorts must pay the funding rate to the longs to curb excessive pessimism among the shorts.

Funding rate settlement cycle: Generally settled every 8 hours, meaning users holding contracts during each settlement cycle must pay or receive the funding rate.

1.3 How to Understand the Funding Rate Mechanism of Perpetual Contracts in Simple Terms

The funding rate mechanism of perpetual contracts can be likened to the rental market:

• Tenant (Long) = Investor buying perpetual contracts
• Landlord (Short) = Investor shorting perpetual contracts
• Average Rent (Mark Price) = Average price in the spot market
• Actual Rent Price (Real-Time Contract Price) = Market transaction price of the perpetual contract

For example:

If there are too many tenants (longs), the rent (contract price) is driven up beyond the market average (mark price), then the tenants need to pay a red packet (funding rate) to the landlord to bring the rent down.

If there are too many landlords (shorts), causing the rent to be pushed down, then the landlords need to pay a red packet to the tenants to bring the rent back up.

Essentially, the funding rate acts as a dynamic balance adjustment tax in the market, punishing the party that "disrupts market equilibrium" and rewarding the party that "corrects market equilibrium."

2. Funding Rate Arbitrage Strategies: Three Methods, but the Source of Profit is Consistent

2.1 Financial Explanation of Funding Rate Arbitrage

The core of funding rate arbitrage lies in: hedging spot and contract positions to lock in funding rate profits while avoiding price volatility risks. The basic logic includes:

• Direction Judgment of Rates: Based on long and short forces, when the funding rate deviates significantly, there is considerable arbitrage potential.
• Risk Hedging: By holding opposite positions in spot and contracts, price volatility risks are offset, allowing for profit solely from the funding rate.
• High-Frequency Compounding: Settlements occur every 8 hours, leading to significant compounding effects.

Essentially, funding rate arbitrage is a Delta-Neutral Strategy, locking in a specific profit factor (funding rate) without bearing directional price risk.

2.2 Three Methods of Funding Rate Arbitrage

1) Single Currency Single Exchange Arbitrage (Most Common)

Specific operational steps:

a. Direction Judgment: If the funding rate is positive and longs pay fees, it is suitable to short the contract and go long on the spot.

b. Establish Position: Short perpetual contract + Long spot.

c. Collect Fees: Assuming the underlying spot rises, the short contract in the combination incurs a loss, but the gains and losses offset, while the futures contract long must pay you the funding fee, earning the funding rate profit.

2) Single Currency Cross-Exchange Arbitrage

Specific operational steps:

a. Scan Exchange Funding Rates: Choose two exchanges with sufficient liquidity and significant differences in funding rates.

b. Establish Position: Short perpetual contract (Exchange A) + Long perpetual contract (Exchange B).

c. Earn Funding Rate Spread: Profit from the difference in funding rates between the exchanges.

3) Multi-Currency Arbitrage

Specific operational steps:

a. Choose Highly Correlated Currencies: That is, currencies with highly similar trends, utilizing funding rate differentiation to hedge direction through position combinations and earn profits.

b. Establish Position: Short high funding rate currency (e.g., BTC) + Long low funding rate currency (e.g., ETH), adjusting positions according to ratios.

c. Earn Profits: Funding rate difference + Volatility profits.

Among the three methods, the difficulty increases sequentially, with most practical operations being the first method. The second and third methods have high requirements for execution efficiency and trading latency. On this basis, leverage can also be added for enhanced arbitrage, but this requires higher risk control and entails greater risks.

Additionally, there are more advanced practices based on funding rate arbitrage, such as combining spread arbitrage and term arbitrage to enhance returns and improve capital efficiency. Spread arbitrage refers to profiting from price differences of the same underlying asset across different exchanges (spot vs. perpetual contracts). When market volatility is high or liquidity is unevenly distributed, funding rate arbitrage can be combined with spread arbitrage to further increase strategy returns; term arbitrage refers to profiting from price differences between perpetual contracts and traditional futures contracts, as the funding rate of perpetual contracts changes with market sentiment, while traditional futures contracts are settlement contracts, thus creating a certain price difference.

In summary, regardless of the hedging arbitrage method, it is essential to achieve complete risk hedging against price volatility; otherwise, profits will be eroded. Additionally, costs must be considered: such as transaction fees, borrowing costs (if leveraged), slippage, margin occupation, etc. As the overall market matures, the returns of simple strategies will diminish, requiring the integration of algorithmic monitoring, cross-platform arbitrage, and dynamic position management to sustain profitability. More advanced arbitrage + spread models demand high execution efficiency and market monitoring capabilities, suitable for institutional investors or quantitative trading teams with certain technical abilities and risk control systems.

3. Institutional Advantages: Why Retail Investors "See but Cannot Eat," What is the Reason?

Funding rate arbitrage may seem logically simple, but in practice, institutions have established significant advantages through technological barriers, economies of scale, and systematic approaches.

3.1 Opportunity Identification Dimension: Dimensionality Reduction in Speed and Breadth

Institutions monitor thousands of cryptocurrencies' funding rates, liquidity, correlations, and other parameters in real-time through algorithms, identifying arbitrage opportunities in milliseconds.

Retail investors rely on manual methods or third-party tools (such as Glassnode), which can only cover hourly lagging data and focus on a few mainstream cryptocurrencies.

3.2 Opportunity Capture Efficiency: Cost Gap Under Technical and Volume Differences

With the significant advantages in the entire technical system and cost control, the arbitrage profit gap between institutions and retail investors can be several times.

3.3 Risk Control System: System-Level Risk Response and Manual Game Theory

From a risk control perspective, institutions have mature systems for managing position risks, allowing timely operations in extreme situations, with options to reduce positions or supplement margins to mitigate risks, while retail investors often respond slowly and have limited means in extreme situations. This is mainly reflected in the following differences:

a. Response Speed: Institutions respond in milliseconds, while individuals at least take seconds, and when not closely monitoring, it can even be minutes or hours, making it difficult to ensure rapid responses.

b. Precision of Risk Control Measures: Institutions can accurately calculate and reduce positions of certain cryptocurrencies to reasonable levels or choose to supplement margins within reasonable ranges, dynamically adjusting to ensure no risks occur; individuals lack the ability for precise calculations and operations, typically only able to choose market price liquidation.

c. Multi-Currency Handling: When risks need to be addressed, institutions can handle dozens to hundreds of cryptocurrencies simultaneously, minimizing operational losses for each currency; individuals can at most handle a few currencies sequentially in a single-threaded manner.

4. Outlook on Arbitrage Strategies and Investor Adaptation

4.1 Differences in Institutional Arbitrage Strategies and Market Capacity

Many may wonder if institutions all adopt arbitrage, whether the market's capacity can support this and whether it will reduce profits. In fact, in the overall logic, institutions exhibit clear "similarities and differences."

Similarities: The same type of strategy, such as arbitrage, has roughly the same strategic thinking;

Differences: Each institution has its own strategic preferences and unique advantages, such as some institutions focusing on large cryptocurrencies and deeply exploring opportunities in them, while others focus on small cryptocurrencies and excel in currency rotation.

Secondly, from the perspective of market capacity limits, arbitrage strategies represent the highest capacity among stable return strategies in the market, with capacity depending on the overall liquidity of the market; a rough estimate suggests that the current overall arbitrage capacity exceeds 10 billion. However, this capacity is not fixed and forms a dynamic balance with liquidity growth, strategy iteration, and market maturity, especially with the rapid growth of crypto derivatives platforms, which will increase the overall arbitrage space.

Although there is competition among institutions, due to slight strategic differences, different cryptocurrencies, and varying technical understandings, the current capacity does not significantly lower returns.

4.2 Investor Adaptation

As long as there is a mature risk control system, arbitrage strategies typically carry very low risk and rarely experience drawdowns. For investors, the main burden is the opportunity cost of relative returns: during relatively sluggish market trading periods, arbitrage strategies may remain in low yield for extended periods; during favorable market conditions, explosive returns usually do not match those of trend-following strategies. Therefore, arbitrage strategies are relatively more suitable for conservative investors.

From an advantage perspective, low volatility and low drawdown make them a safe haven for funds during bear markets, favored by risk-averse and conservative funds, such as family offices, insurance funds, mutual funds, and high-net-worth individual wealth allocations.

From a disadvantage perspective, the upper limit of returns is not as high as trend strategies, with arbitrage strategies typically yielding annualized returns of 15%-50%; this is lower than the upper limits of long strategies/trend strategies (which can theoretically be 1 to several times).

For ordinary retail investors, personal operational arbitrage represents an investment of "low returns + high learning costs," with a poor risk-return ratio, making it more advisable to participate indirectly through institutional asset management products.

Funding rate arbitrage represents "certain returns" in the crypto market, but the gap between retail and institutional investors does not lie in cognition, but rather in the obvious disadvantages of "technology, costs, and risk control." Instead of blindly mimicking, it is better to choose transparent and compliant institutional arbitrage products as a "ballast" for asset allocation.

Disclaimer

This document is for internal reference only by 4Alpha Group, based on 4Alpha Group's independent research, analysis, and interpretation of existing data. The information contained in this document is not investment advice and does not constitute an offer or invitation to residents of the Hong Kong Special Administrative Region, the United States, Singapore, or other countries or regions where such offers are prohibited to purchase, sell, or subscribe to any financial instruments, securities, or investment products. Readers should conduct their own due diligence and seek professional advice before contacting us or making any investment decisions.