Perpetual swaps are futures contracts without an expiration date. Unlike regular futures, they need a mechanism to keep the contract price anchored to the underlying asset price. This is where the funding rate comes in.
The funding rate is paid between traders. If the perpetual is trading above spot, longs pay shorts the funding rate. This incentivizes shorts to open positions and longs to close them, pushing the price back down. The mechanism works because funding rates are typically positive when markets are bullish, so longs have to pay.
Think of the funding rate as the cost of leverage. If you're long on a perp, you're paying the difference between the perp price and the spot price, compounded with funding. This cost should roughly equal what you'd pay for actual leverage through lending. On well-functioning exchanges, the funding rates settle this.
Cash-and-carry is the classic trade here. Buy spot, short the perpetual, collect funding. If funding is high enough, you're getting paid just to hold the asset. The arbitrage works because funding rates spike during bullish sentiment when leverage is expensive. This trade is how the market corrects perp prices that drift too far from spot.
Liquidations work differently across exchanges. Some mark-to-market at the last traded price, which can cause cascades. Others use an index price or time-weighted average. FTX used a sophisticated liquidation engine. Binance liquidates more conservatively. The liquidation mechanism matters because poorly designed ones can spiral into contagion during volatile moments.
One pattern I've noticed: on newer exchanges with less liquidity, funding rates are higher and more volatile. This compensates traders for worse execution, but it also means more opportunities for sophisticated traders who can quickly arb deviations. Exchanges with deep liquidity (Binance, dydx) have lower, more stable funding rates.
Perpetuals are essentially a pricing game. The funding rate converges on whatever level balances supply and demand for leverage. More demand for long leverage pushes funding positive. More demand for short leverage pushes it negative. The market finds equilibrium.