Before diving into how this quantitative fund operates and discussing its pros and cons, let’s first understand what the funding rate is.

What is the Funding Rate?

The funding rate is a key mechanism in the cryptocurrency market for perpetual contracts, used to adjust the price gap between the contract price and the underlying asset’s price. It is a periodic cash flow exchange between long and short traders. Depending on market conditions, the funding rate can be either positive or negative:

• Positive Funding Rate: Long-position traders pay funding fees to short-position traders. This typically occurs when the market is bullish, and the perpetual contract price is higher than the spot market price.
• Negative Funding Rate: Short-position traders pay funding fees to long-position traders. This generally happens when the market is bearish, and the perpetual contract price is lower than the spot market price.

The funding rate’s main purpose is to align perpetual contracts’ price with the spot market price, thus maintaining market balance.

The Importance of the Funding Rate

The key distinction between perpetual contracts and traditional futures contracts is that perpetual contracts have no expiration date, thus allowing traders to hold positions indefinitely. Cryptocurrency exchanges implement the funding rate mechanism to prevent prices from deviating significantly from the underlying asset’s price. The roles of the funding rate include:

1. Price Anchoring: Ensures that perpetual contracts’ price stays in line with the underlying asset (spot price or index price).
2. Market Balance: By charging a funding fee, the funding rate encourages traders to take opposite positions when prices deviate, reducing the extent of the deviation.
3. Enhancing Liquidity: When the funding rate mechanism operates smoothly, the trading experience of perpetual contracts becomes similar to that of the spot market, attracting more investors to participate.

Funding Rate vs. Contango and Backwardation in Traditional Futures Markets

Contango and Backwardation

In traditional futures markets:

• Contango: Futures prices are higher than spot prices, usually reflecting the cost of capital and storage.
• Backwardation: Futures prices are lower than spot prices, typically reflecting the scarcity of the underlying asset or strong short-term demand.

Relationship Between Funding Rate and Contango/Backwardation

The funding rate serves as a dynamic adjustment mechanism in the perpetual contract market, similar to the role of contango and backwardation in traditional futures markets:

1. Contango corresponds to a positive funding rate
   When the perpetual contract price exceeds the spot price, long-position traders pay a funding rate to short-position users, encouraging short traders to enter and reduce the contract price. This is akin to the positive price difference observed in traditional futures markets, where investors pay the cost of holding futures contracts.

1. Backwardation corresponds to a negative funding rate
   When the perpetual contract price is lower than the spot price, short-position traders pay a funding rate to long-position users, encouraging long traders to enter and push the contract price up. This mirrors the backwardation scenario in traditional futures markets, where futures prices are lower due to the short supply of the underlying asset.

1. Dynamic Adjustment of the Funding Rate
   Unlike the static price differences in traditional futures, the funding rate of perpetual contracts is recalculated periodically (typically every 8 hours), dynamically adjusting based on market conditions to prevent prolonged price deviations.

Calculation of Funding Fees

The funding fee is calculated as follows:

Funding Fee = Nominal Contract Value × Funding Rate

Where:

• Nominal Contract Value: The value of the position linked to the mark price, used to avoid the impact of extreme price fluctuations.
• Funding Rate: Based on the market’s long and short forces and the price deviation of the underlying asset, it is typically derived from interest rate differentials and price basis.

For example, in Gate.io’s perpetual contracts, most assets’ funding fees are recalculated every 8 hours. A few assets, such as PNUTUSDT, have funding fees calculated every 4 hours to adjust more promptly to market conditions.

Funding Rate Arbitrage: A Stable Cryptocurrency Investment Strategy

Funding rate arbitrage is a market-neutral strategy specifically designed for the cryptocurrency market, aiming to generate stable returns by leveraging the funding rate mechanism of perpetual contracts. The core principle is to establish hedged positions in both the spot market and the perpetual contract market, thus balancing the effects of market fluctuations to achieve stable profit generation.

The specific operation works as follows: investors purchase spot assets of equivalent value to the underlying perpetual contract while simultaneously establishing an equal-value short position in the contract market. This position configuration ensures that market price movements have little to no impact on the overall portfolio value. For example, when the price rises, the value of the spot position increases, while the value of the short position decreases, and the two effects cancel each other out. The primary source of returns is the funding rate of the perpetual contract. When the market is bullish, long traders pay funding fees to short traders, and arbitrageurs benefit from stable profits.

Additionally, by using the exchange’s cross-margin system, the margin for spot and contract positions can be combined. This allows for increased leverage and more capital deployment. This amplifies potential returns and allows the strategy to achieve higher profits as the capital scale expands, thus making the strategy more attractive.

Stability and Low Risk: The Advantages of Funding Rate Arbitrage

The key advantage of funding rate arbitrage lies in its stability and relatively low risk. The hedging between spot and contract positions helps minimize the effects of market volatility on the portfolio’s value. For investors, this strategy is largely impervious to price fluctuations, with profits mainly stemming from the funding rate itself.

Compared to traditional financial products like time deposits or fixed-income products, funding rate arbitrage typically offers higher returns, especially when market sentiment is bullish. This makes it a more attractive investment option than time deposits. For example, in 2024, the U.S. benchmark interest rate is around 5% annually, while the funding rate arbitrage strategy in Gate.io’s quantitative fund can yield returns of over 15%.

Risks and Limitations: Challenges of Funding Rate Arbitrage

Although funding rate arbitrage appears stable, it is not without risks. During bearish market conditions, the funding rate can turn negative, thus requiring arbitrageurs to adjust their strategies dynamically. Such changes increase operational complexity and incur additional transaction costs, which may reduce the net benefit from the funding rate and even result in potential losses.

Moreover, the strategy’s profitability depends entirely on the funding rate level. When market activity is low, or the funding rate approaches zero, the profit potential is significantly reduced. Extreme market conditions, such as liquidity shortages or changes in exchange policies, can also make the strategy less effective and disrupt its execution.

What is a Funding Rate Quantitative Fund?

A funding rate quantitative fund is an investment portfolio that operates in the cryptocurrency perpetual contract market. It utilizes the funding rate arbitrage strategy described above. The core advantage of this quantitative fund lies in its trading system, which uses precise mathematical models and algorithms to capture funding rate discrepancies in the market. It automatically identifies the most attractive funding rate opportunities, performs risk assessments, and manages positions. Automated trading improves execution efficiency and minimizes errors that might arise from human judgment.

In professional quantitative teams, issues that ordinary investors encounter can be solved systematically. First, the team establishes a comprehensive risk monitoring system that continuously tracks market sentiment indicators, volatility, trading volume, and other multi-dimensional data. This allows them to issue early warnings before the funding rate turns negative. When market conditions deteriorate, the system automatically reduces positions or even temporarily exits, rather than passively bearing losses as retail traders might do.

On the technical side, quantitative fund teams possess strong research and development capabilities. They have developed high-frequency trading systems that monitor the market and execute orders in milliseconds, significantly reducing the risk of spot-futures price differences. Additionally, they continuously perform data analysis to evaluate the cost-benefit ratio of each trade precisely, ensuring stable profitability even in high-frequency trading environments.

To address liquidity concerns, the fund employs algorithms and financial models to rotate assets. The system can switch between pairs at optimal times by analyzing liquidity indicators and funding rate performance across different trading pairs. When liquidity for a specific pair declines or its funding rate worsens, the system promptly reallocates funds to better-performing pairs, thus maintaining the stability of the overall strategy.

A combination of multiple assets and strategies makes the portfolio stable even if a single trading pair or strategy faces adverse market conditions. This professional portfolio management capability, advanced technical support, and strict risk control enable quantitative funds to offer more stable and professional asset management services—an advantage that retail investors typically lack.

This explains why, in the cryptocurrency market, choosing a professional quantitative team for investment management often leads to better risk-return ratios compared to individual investing. The team systematically avoids various risks and uses its technical edge to capture more market opportunities, ultimately achieving stable profits.

Simple Backtest of Funding Rate Arbitrage

Figure 1: Funding rate amounts for BTC_USDT perpetual contracts, with rolling_90 and rolling_30 representing the average funding rates over the past 90 and 30 periods, respectively.

Figure 1 shows the funding rates for the BTC_USDT perpetual contract trading pair on Gate.io in 2024. The average funding rate per period is 0.0081%, indicating that, over the long term, a positive funding fee is collected. Shorting the BTC_USDT perpetual contract will yield approximately 0.0081% per period.

Figure 2: Funding rate arbitrage backtests for BTC_USDT perpetual contract. The blue line represents 1x leverage, while the red line represents 2x leverage, showing the cumulative return after collecting funding rates.

Figure 2 presents a simple backtest for the BTC_USDT perpetual contract funding rate arbitrage. Assuming we buy $5,000 worth of BTC in the spot market and short $5,000 of BTC perpetual contracts, for a total value of $10,000, on January 1, 2024, and close the position on December 31, 2024, we can obtain the funding value shown in the figure. The blue line represents the cumulative return with 1x leverage, while the red line represents the cumulative return with 2x leverage under a cross-margin system.

Simple calculations show that with 1x leverage, the annualized return is approximately 4.4%. Leveraging up to 2x through the cross-margin system can increase the annualized return by 8.8%. Using more volatile tokens can yield even higher returns, and by diversifying across multiple funding rate trading pairs, a multi-asset quantitative fund can be created to further enhance returns.

Figure 3: Cumulative return from funding rate arbitrage with 1x leverage across different perpetual contract trading pairs.

Figure 4: Cumulative return from funding rate arbitrage with 2x leverage across different perpetual contract trading pairs.

Figure 3 shows the backtest of multiple tokens with longer trading histories in the market. After performing funding rate arbitrage, the annualized returns for different contracts vary. The highest annualized return is for DOGE_USDT at 7.245%, followed by LINK_USDT at 6.027%. Other contracts have annualized returns ranging from 4.5% to 6%. We observe that BTC_USDT contracts, with less volatility than altcoins, tend to have lower funding rates and, therefore, lower annualized returns. In contrast, altcoins with higher volatility have higher annualized returns.

Figure 4 illustrates the cumulative returns for the same pairs shown in Figure 3, but with 2x leverage under the cross-margin system. Despite the increased leverage, the returns remain stable, with the majority of contracts yielding annual returns around 10%. Professional quantitative fund strategies can identify more favorable assets and deliver enhanced annual returns through advanced algorithms and portfolio management.

Conclusion

In conclusion, funding rate arbitrage is a stable investment strategy well-suited for investors seeking consistent returns in volatile markets. While it does have some limitations, as long as market liquidity is adequate and the funding rate remains positive, this strategy can offer a “near-risk-free” source of returns in most cases. Funding rate arbitrage provides a more appealing alternative for investors familiar with traditional financial products like time deposits or bonds. However, choosing exchanges carefully and accounting for liquidity risks is crucial. Exchanges with sufficient reserves are better positioned to avoid default or bankruptcy risks, and in this regard, Gate.io is more prepared than many other exchanges in the industry.