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

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 crypto market's 24-hour uninterrupted trading environment, a special derivative was born - the perpetual contract.

Core Differences between Perpetual Contracts vs. Traditional Futures Contracts:

· No Settlement Date: Perpetual contracts have no settlement date, allowing users to hold positions long-term with sufficient margin and without liquidation.

· Funding Rate Mechanism: Anchoring spot prices through the Funding Rate to keep contract prices consistent with spot index prices long-term.

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

· Mark Price: Used to calculate liquidation, determined by weighted average spot prices from multiple trading platforms to prevent market manipulation.

· Real-time Trading Price: Actual market trading price, determining users' entry costs.

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

1.2 What is Funding Rate

Funding Rate is a mechanism in perpetual contracts used to adjust market long and short forces, with the core purpose of keeping contract prices as close to spot prices as possible.

In specific calculations, funding rate consists of a premium part + fixed part, where premium refers to the deviation between the contract's real-time trading price and spot index price.

· Premium Rate = (Contract Price - Spot Index Price) / Spot Index Price

· Fixed Rate = Basic rate set by the trading platform

When funding rate is positive, it means the contract price is higher than the spot price, with an overly strong long market, requiring longs to pay funding rate to shorts to suppress excessive optimism.

When funding rate is negative, the opposite occurs, with shorts paying fees to longs to suppress excessive pessimism.

Funding Rate Settlement Cycle: Generally settled every 8 hours, with users holding contracts during each settlement period paying or receiving funding rates.

1.3 A Layman's Understanding of Perpetual Contract Funding Rate Mechanism

The perpetual contract funding rate mechanism can be compared to the rental market:

· Tenant (Long) = Investors buying perpetual contracts

· Landlord (Short) = Investors shorting perpetual contracts

· Area Average Price (Mark Price) = Spot market average price

· Actual Rental Price (Contract Real-time Price) = Perpetual contract market trading price

Example:

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

If there are too many landlords (shorts), causing rent to be pushed down, landlords need to pay a red packet to tenants to raise rent.

Essentially, funding rate is a dynamic market balance adjustment tax, punishing the party "disrupting market equilibrium" and rewarding the party "correcting market equilibrium".

Under the huge advantages of the entire technical system and cost control, the arbitrage income gap between institutions and retail investors may be several times higher.

3.3 Risk Control System: Systematic Risk Response and Human Gambling

From the overall risk control perspective, institutions have a mature system for controlling position risks, can operate in a timely manner during extreme situations, and can choose to reduce positions, supplement margins, and other means to reduce risks. Retail investors have untimely responses and limited means during extreme conditions. This is mainly reflected in the following differences:

a, Response Speed: Institutional response speed is millisecond-level, while individual response is at least second-level, and when not paying close attention, it can even be minute or hour-level, making it difficult to ensure a quick response

b, Risk Control Precision: Institutions can accurately calculate and reduce positions of certain cryptocurrencies to a reasonable level, or choose to supplement margins to a reasonable range, dynamically adjusting to ensure no risk occurs; individuals lack the ability to calculate and operate precisely, and can basically only choose market price liquidation

c, Multi-cryptocurrency Handling: When risks need to be handled, institutions can simultaneously process at least dozens or hundreds of cryptocurrencies, minimizing operational losses for each; individuals can at most handle single-threaded, single-digit cryptocurrencies in sequence.

4. Outlook and Investor Adaptation of Arbitrage Strategies

4.1 Institutional Arbitrage Strategy Differences and Market Upper Limit

Most people would wonder if the market capacity can support institutional arbitrage and whether it will reduce returns. In fact, institutions show obvious "similarities and differences" in their overall logic.

· Similarities: For the same type of strategy, such as arbitrage, the strategic thinking is roughly the same;

· Differences: Each institution has its own strategy preference and unique advantages, such as some institutions focusing on large cryptocurrencies and deeply exploring opportunities, while others specialize in small cryptocurrencies and are good at cryptocurrency rotation.

Secondly, from the market capacity upper limit perspective, arbitrage strategy is the highest capacity stable income strategy in the market, and its capacity depends on the overall market liquidity; a rough estimate suggests the current overall arbitrage capacity exceeds 10 billion. However, this capacity is not fixed but forms a dynamic balance with liquidity growth, strategy iteration, and market maturity, especially with the rapid growth of crypto derivatives platforms, which will bring growth to the entire arbitrage space.

Despite competition among institutions, due to subtle strategy differences, different cryptocurrencies, and different technical understandings, the current capacity will not significantly lower the return rate.

4.2 Investor Adaptation

Arbitrage strategies with a mature risk control system typically have extremely low risk and rarely experience drawdowns. For investors, the main opportunity cost is relative returns: during periods of relatively sluggish market trading, arbitrage strategies may remain in low returns; during good market times, the explosive returns are usually not as good as trend strategies. Therefore, arbitrage strategies are relatively more suitable for conservative investors.

From the advantages, low volatility and low drawdowns make it a capital safe haven during bear markets, more favored by risk-averse and stable funds, such as family offices, insurance funds, mutual funds, and high-net-worth individual wealth allocations.

From the disadvantages, the return ceiling is lower than trend strategies, with arbitrage strategies' annual returns ranging from 15%-50%; lower than the return ceiling of long/trend strategies (theoretically 1 to several times).

For ordinary retail investors, personal arbitrage implementation is "low returns + high learning costs" with poor risk-reward ratio, and it is more recommended to participate indirectly through institutional asset management products.

Funding rate arbitrage is a "certain income" in the crypto market, but the gap between retail investors and institutions is not in cognition, but in the obvious disadvantages of "technology, cost, and risk control". Instead of blindly imitating, it is better to choose transparent and compliant institutional arbitrage products as the "ballast" of asset allocation.

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