Summary
This article explores the development and significance of funding rates in the cryptocurrency derivatives market, focusing on the origins, mechanics, and the arbitrage strategies they inspire. It reviews the 'golden age' of funding rate arbitrage in the spring of 2021 and the subsequent downturn caused by market adjustments; it also analyzes the revival of funding rate arbitrage opportunities in 2024-2025 with the emergence of innovative stablecoins like USDe and USDX. Furthermore, the article discusses the key role of the Chicago Mercantile Exchange (CME) in funding rate pricing, revealing the intersection between traditional finance (TradFi) and decentralized finance (DeFi). Finally, the article argues that the dynamics of funding rates are more influenced by institutional investors and CME rather than emerging stablecoins, calling for a reevaluation of the narrative logic within the crypto ecosystem.
Origins of funding rates
Funding rates originated in the cryptocurrency derivatives market, specifically developed from perpetual futures contracts. It serves as a mechanism to keep the prices of perpetual futures contracts close to the spot prices of the underlying assets. The development of this concept aimed to address inherent issues in traditional futures contracts, such as expiration and settlement, which could lead to discrepancies between futures and spot prices.
Key context for funding rates:
Introduced by cryptocurrency exchanges: Funding rates became widely recognized and utilized with the rise of cryptocurrency exchanges like @BitMEX (founded by @CryptoHayes in 2016). BitMEX promoted perpetual futures contracts, a type of derivative financial product without an expiration date, allowing traders to hold positions indefinitely. To ensure that the contract price remains close to the spot price, funding rates were introduced.
Mechanism: Funding rates are the fees paid (or received) periodically between longs (buyers) and shorts (sellers) in the market. It is determined by the difference between the price of the perpetual futures contract and the spot price of the underlying asset. If the perpetual contract price is higher than the spot price (indicating a bullish market), longs pay funding to shorts; if the price is lower than the spot price (indicating a bearish market), shorts pay funding to longs.
Purpose: Funding rates incentivize traders to take positions that help align the price of perpetual futures with the spot price. This reduces the potential for significant discrepancies, maintaining market efficiency.
Calculation: The calculation of funding rates is based on two main components: interest rates (usually negligible) and the premium index (the difference between futures prices and spot prices). Specific formulas may vary between exchanges.
Evolution: Funding rates have become a standard feature across major cryptocurrency exchanges, including Binance, OKX, Bybit, and Deribit Exchange. It has influenced traditional financial derivatives by introducing innovative methods to manage price tracking and trader behavior.
Funding rates play a critical role in ensuring the stability and efficiency of the cryptocurrency perpetual futures market, keeping it closely aligned with the underlying spot market.
What is funding rate arbitrage?
Funding rate arbitrage is a trading strategy where traders profit from the differences between the funding rates of perpetual futures contracts and the spot prices of the underlying assets. The goal is to profit from periodic funding payments between longs and shorts.
Key elements:
Long spot + short perpetual futures: Traders buy cryptocurrencies (e.g., Bitcoin) in the spot market while establishing short positions on perpetual futures contracts of the same cryptocurrency. This creates a hedged position, shielding traders from asset price fluctuations.
Profiting from high funding rates: When funding rates are high (bullish market), traders with short positions receive funding payments from traders holding long positions.
Spring 2021 - The golden age of arbitrage
The spring of 2021 is often referred to as the 'golden age of funding rate arbitrage' in the cryptocurrency market, as funding rates were abnormally high at the time, creating opportunities for traders to profit from arbitrage strategies. Explaining why this period was prominent and how funding rate arbitrage works:
Explosive market growth
The cryptocurrency market experienced unprecedented growth in early 2021, driven by factors including:
Institutional adoption of Bitcoin and other cryptocurrencies (e.g., Tesla, MicroStrategy).
The prosperity of DeFi and increased retail participation.
Bullish sentiment driving Bitcoin and Ethereum to new peaks.
This led to a continued premium for perpetual futures contracts as bullish traders dominated the market.
Abnormally high funding rates
As long positions significantly outnumber short positions, funding rates spiked to historical highs. For example:
At exchanges like Binance and Bybit, Bitcoin perpetual funding rates often exceed 0.1% to 0.3% every 8 hours. On an annualized basis, this equates to returns of 36% to 108%, far exceeding traditional fixed-income investments.
Arbitrage-friendly market conditions
Market inefficiencies: Significant premiums in perpetual futures prices create consistent funding payments. High liquidity: Major exchanges have rich liquidity, allowing traders to effectively execute arbitrage strategies. Low counterparty risk: The introduction of custodial insurance solutions and wallets provided by exchanges reduces the risks of holding large amounts of cryptocurrency for arbitrage.
How traders can seize this opportunity
Hedging through spot or traditional futures: Traders collect funding payments by holding long positions in the spot market while holding short positions on perpetual futures contracts, without bearing price risks.
Institutional participants entering arbitrage: Hedge funds, proprietary trading firms, and savvy individual investors actively enter the funding rate arbitrage industry, deploying significant capital to lock in stable profits.
Annualized returns: In some cases, annualized yields exceed 100%, making funding rate arbitrage one of the most attractive risk-free strategies in the crypto market.
Decline after prosperity
By mid-2021, funding rates normalized because:
The market experienced a correction after Bitcoin reached $64,000 in April 2021, followed by a sharp decline in May.
Increased competition in arbitrage has reduced profitability.
The emergence of more efficient market participants (such as automated market makers and quantitative funds) has begun to stabilize funding rates.
Legacy of spring 2021: Expansion functionalities
The golden age of funding rate arbitrage in the spring of 2021 left an indelible mark on the cryptocurrency ecosystem, demonstrating that the index growth of the market has both potential and vulnerabilities. While this period highlighted abundant opportunities under bullish market conditions, it also laid the groundwork for significant systemic risks that became apparent in the following years.
Opportunities and market growth
Highlighting the dynamics of funding rates: The high funding rates during this period emphasize the unique role of perpetual futures contracts in the crypto market as speculative and price discovery tools. Traders and fund management companies capitalized on arbitrage opportunities created by the differences between spot and perpetual prices driven by bullish sentiment. · Rise of institutional participation: Arbitrage-friendly conditions attracted institutional participants and complex fund management companies that began deploying large amounts of capital in the crypto market. This influx of institutional interest enhanced the legitimacy of cryptocurrencies as an asset class and accelerated the innovation of financial products.
Surge in circulating supply of USDT: One of the most significant outcomes of this period was the sharp increase in the circulating supply of the key stablecoin @Tether_to_toTether (USDT). From early 2021 to mid-2021, the supply of USDT surged from $4 billion to over $60 billion, reflecting a massive inflow of fiat capital into the crypto market. This facilitated trading, arbitrage, and liquidity provision between exchanges.
Chain reaction of events after 2021
Despite the optimism of spring 2021, its legacy also includes exposing vulnerabilities that led to a series of catastrophic events:
Capital inflow into Anchor Protocol (Terra/Luna founded by Do Kwon): As fund management companies sought higher yields, a significant portion of capital flowed into high-yield platforms like Anchor Protocol, the flagship DeFi project on the Terra blockchain. Anchor attracted capital through Terra's UST algorithmic stablecoin system, offering unsustainable high APY (up to 20%). This created a fragile structure that required new capital inflows to maintain yields.
The crypto market crash in May 2022: The collapse of Terra in May 2022 symbolized one of the largest financial collapses in crypto history. When Anchor Protocol was unable to maintain its yields, the decoupling of UST triggered a death spiral for LUNA, resulting in over $50 billion in market value evaporating, erasing much of the cryptocurrency supply.
Impact on FTX and Alameda (founded by SBF): FTX/Alameda, as significant players in the crypto ecosystem, became major victims of the Terra collapse. Alameda's exposure to Terra and its role in providing 'exit liquidity' for Terra/Luna losses resulted in billions of dollars in losses. This laid the groundwork for FTX's collapse in November 2022, exposing a house of cards built on opaque trading practices and mismanagement of funds.
Impact on crypto lending institutions: The collapse of Terra had profound effects on crypto lending institutions and hedge funds: Three Arrows Capital (3AC) (founded by Su Zhu), Genesis (founded by Barry), BlockFi (founded by Zac Prince), Celsius (founded by Alex Mashinsky), and Babel Finance (founded by Flex Yang; notably, Flex Yang returned to restructure the company after retiring from Babel Finance in November 2021 and achieved the only successful restructuring case in 2022) were all significantly exposed to Terra and broader market downturn risks.
The bankruptcies of these entities caused a chain reaction, further eroding market confidence and depleting liquidity.
Key lessons learned from the legacy
Stablecoins and liquidity risks: The rapid growth of stablecoins like USDT in 2021 highlighted their crucial role in providing liquidity. However, over-reliance on algorithmic stablecoins (like UST) without proper risk management exposed systemic vulnerabilities.
Sustainability of DeFi yields: Projects like Anchor illustrate the dangers of unsustainable yield promises, especially when these promises are supported by circular economic models or insufficient reserves.
Interconnectivity of the crypto ecosystem: The crash in 2022 revealed deep connections between crypto companies, where the failure of one element (like Terra/Luna) can trigger a chain reaction through lending, trading, and investment platforms.
Importance of risk management: These events highlight the need for improved risk management and transparency across crypto companies, including better regulation of stablecoins, lending practices, and centralized exchanges.
Reflections on the golden age of 2021
The 'golden age' of spring 2021 not only symbolized the peak of speculative fervor and financial innovation in the crypto market but also sowed the seeds for a subsequent series of failures. The surge of capital inflows, exemplified by the dramatic increase in USDT supply, propelled market growth while also creating systemic risks that later destabilized the entire ecosystem. These events underscored the need for sustainable growth, robust risk management, and greater oversight in the maturation process of the cryptocurrency industry.
2024-2025: The revival of funding rate arbitrage and USDe and USDX
Between 2024 and 2025, funding rate arbitrage experienced a revival, thanks to the rise of innovative stablecoins like USDe (founded by Guy) launched by Ethena and USDX (founded by Flex Yang) from Stables Labs. These next-generation stablecoins aim to address the systemic weaknesses exposed by the collapse of algorithmic stablecoins (like UST) and create new opportunities for traders and institutions in the funding rate arbitrage industry.
Key drivers of revival
Evolution of stablecoins
USDe (Ethena):
USDe introduces a novel model that combines on-chain collateral and complex risk management tools to ensure stability. It is designed to provide resilience similar to fiat-backed stablecoins like USDT while leveraging the transparency and decentralized mechanisms of on-chain.
USDX (Stables Labs):
USDX adopts a similar mechanism, but it is backed by a multi-currency strategy. This strategy offers a higher risk-adjusted return than USDe and can avoid negative funding rates.
Its dynamic stabilization mechanism mitigates the risk of cascading failures, providing a reliable medium for arbitrage strategies. These stablecoins are designed to maintain a consistent peg to the dollar while offering competitive yields, making them ideal tools for funding rate arbitrage.
Market maturity and efficiency
Infrastructure improvements:
Decentralized exchanges (DEXs) and derivative product protocols have made significant progress, offering higher liquidity, lower slippage, and better transparency compared to previous cycles.
Regulatory clarity:
After the 2022 crash, the regulatory framework for stablecoins and derivatives markets became clearer, restoring trust in the ecosystem and attracting institutional investors back to arbitrage strategies.
High funding rate periods
Renewed interest in cryptocurrencies as an asset class has led to a resurgence of bullish sentiment, driving up funding rates in the perpetual futures market.
The introduction of tokenized real-world assets (RWAs), including tokenized stocks, bonds, and commodities, expands the perpetual futures market beyond traditional crypto assets, creating arbitrage opportunities across multiple asset classes.
Institutional participation
Hedge funds, proprietary trading firms, and other institutional participants have embraced funding rate arbitrage as a low-risk, high-reward strategy in the crypto derivatives market.
The support for complex stablecoins like USDe and USDX provides reliable liquidity and stability for arbitrage trading.
Mechanisms for the new revival of arbitrage
Classic arbitrage: Holding spot, selling perpetual contracts
Traders utilize USDe and USDX to execute hedging positions:
Holding spot: Purchase the underlying cryptocurrency (such as Bitcoin or Ethereum).
Sell perpetual contracts: Sell perpetual futures contracts of the same cryptocurrency.
During bullish periods, high funding rates in the perpetual market allow traders to profit from funding payments without bearing the risk of price fluctuations.
Enhancing yields through stablecoin integration
Yield enhancement: USDe and USDX offer integrated staking or yield generation mechanisms, allowing traders to earn additional interest from their stablecoin holdings while participating in arbitrage.
Capital efficiency: These stablecoins are optimized for DeFi protocols, allowing traders to maximize leverage while maintaining lower risk levels.
Cross-asset arbitrage
Beyond cryptocurrencies, traders can now arbitrage between tokenized real-world assets and their traditional counterparts, using stablecoins as a bridge for liquidity.
Economic impact
Rebuilding trust in stablecoins
The success of USDe and USDX highlights the crypto industry's ability to learn from past failures and design resilient financial instruments.
This restored trust in stablecoins attracted a significant inflow of fiat capital, enhancing liquidity across the entire crypto market.
Expansion of arbitrage opportunities
The rise of a diversified derivatives market, including RWAs, has greatly increased opportunities for funding rate arbitrage. Arbitrage strategies now provide price stability for a wider range of assets.
Institutionalization of crypto arbitrage
Funding rate arbitrage has become a core strategy for hedge funds and asset managers, connecting traditional finance with the crypto market.
The entry of institutional capital has accelerated the growth and specialization of the crypto derivatives ecosystem.
Stability of cryptocurrency supply
Unlike the uncontrolled expansion of UST in 2021, the supply growth of USDe and USDX is prudently managed to prevent hyperinflation dynamics.
This controlled growth ensures a more sustainable arbitrage ecosystem.
Risks and challenges
Overreliance on stablecoins
While USDe and USDX offer innovative mechanisms, systemic risks may arise if their models are pressured under extreme market conditions or regulatory changes.
Competition and liquidity fragmentation
The explosion of stablecoins and derivative product protocols may lead to liquidity fragmentation, making it more challenging to execute arbitrage efficiently.
Market saturation
As more participants enter the funding rate arbitrage industry, yields may decrease due to increased competition, similar to the situation after 2021.
Regulatory barriers
As tokenized real-world assets and stablecoins increasingly converge with traditional markets, it may invite stricter regulatory scrutiny, potentially impacting arbitrage strategies.
The rapid decline in funding rates is not due to USDe or USDX, but rather the large positions taken by TradFi hedge funds in the CME after the listing of IBIT.
The pricing of funding rates in the cryptocurrency market is influenced by the CME Group, reflecting the growing interaction between traditional finance (TradFi) and decentralized finance (DeFi) markets.
How CME influences funding rates
CME as a pricing benchmark:
CME's Bitcoin and Ethereum futures contracts are regulated and traded in traditional financial markets. These contracts are often used by institutional investors as pricing benchmarks for derivative financial products, including perpetual futures contracts in the crypto-native market. Since CME futures reflect institutional sentiment and are traded in dollars, they provide reliable anchor points for pricing discrepancies between the spot market and crypto derivatives.
Arbitrage between CME and crypto futures markets:
Traders frequently arbitrage between CME futures and the perpetual crypto markets of exchanges like Binance, OKX, Bybit, and Deribit.
If CME futures are at a premium or discount relative to spot prices, it creates arbitrage opportunities that directly affect the funding rates of perpetual futures:
CME futures premiums: Indicating bullish sentiment, leading to an increase in funding rates for perpetual futures.
CME futures discount: Indicating bearish sentiment, leading to a decrease in funding rates, even turning negative.
Institutional participation drives funding rates:
As CME is the gateway for institutional capital entering the crypto market, its futures prices set the tone for market behavior. Large institutional investors often hedge their CME positions with crypto-native perpetual contracts, keeping the dynamics of funding rates aligned with CME's futures curve.
The mechanism of CME's impact on funding rates
CME basis and spot prices:
CME basis (the difference between CME futures prices and spot prices) has become a key driver of arbitrage flows: High CME basis incentivizes traders to short CME futures while going long on spot or perpetual futures to narrow the gap and influence funding rates.
Low CME basis (or negative basis) triggers opposite trading, affecting funding rates accordingly.
CME futures expirations:
Quarterly expirations of CME futures introduce cyclical patterns in the crypto market: As expiration approaches, large-scale hedging activities may affect funding rates as traders rebalance positions between CME and perpetual futures.
After expiration, the settlement prices of CME contracts often reset market expectations, indirectly affecting the pricing and funding rates of perpetual futures.
Dollar pricing and market anchoring:
CME futures are priced in dollars, providing stability, especially during periods of high volatility, serving as a reference for crypto perpetual contracts.
This dollar anchoring ensures that funding rates reflect not only the dynamics native to crypto but also broader macroeconomic factors impacting traditional markets.
Why CME's influence is significant
Connecting traditional and crypto markets:
As a bridge between institutional capital and the crypto market, CME's influence ensures that funding rates increasingly reflect broader market dynamics rather than being limited to the crypto ecosystem.
Improving efficiency and price discovery:
Arbitrage between CME futures and crypto derivatives reduces market inefficiencies, ensuring tighter price spreads and more accurate pricing in both markets.
Standardization of derivative pricing:
As CME sets standards for regulated futures, its influence on funding rates helps align crypto perpetual contracts with more traditional derivative pricing models, making the market more accessible to institutional investors.
Therefore, do not blame USDe or USDX, but rather the traditional finance hedge funds that exploited their low capital costs for arbitrage!
Here are some of the largest shareholders of the iShares Bitcoin Trust ETF (IBIT):
Top institutional holders of IBIT (iShares Bitcoin Trust ETF)
Source: Fintel data source
Some of these are holders, but most are actually arbitrageurs!
Conclusion
The evolution of funding rates and the strategies they inspired highlight the dynamic intersection of TradFi and DeFi. The 'golden age' of 2021 showcased abundant opportunities but also exposed systemic weaknesses that led to significant market crashes. In 2024-2025, the rise of robust stablecoins like USDe and USDX brings a new wave of arbitrage opportunities, providing a more sustainable framework for market growth.
Ultimately, the pricing of funding rates is not determined by stablecoins but shaped by institutional participation and CME's benchmark futures. The interaction of these forces underscores the importance of market efficiency, transparency, and robust risk management to ensure the continued maturation of the crypto ecosystem. The responsibility for low funding rates should not be blamed on stablecoins like USDe or USDX, but rather on traditional financial participants that exploit their low capital costs and arbitrage strategies.
[Disclaimer] The market is risky; invest with caution. This article does not constitute investment advice, and users should consider whether any opinions, views, or conclusions herein align with their specific circumstances. Invest accordingly at your own risk.
This article is authorized for reprint from: (Rhythm Blockbeats)
'How to arbitrage funding rates? Reviewing the evolution of arbitrage methods, what opportunities do you still have?' This article was originally published in 'Crypto City'
