Sygnum Market View – 31 July 2020
How does the digital asset futures market work?
Bitcoin’s price and funding rate reach one of the highest levels for the year – could this lead to a price consolidation?
Futures are a contractual commitment between two parties to buy or sell an asset at a predetermined date, at a preestablished price. The agreement tracks an underlying, which in the case of crypto futures is a digital asset.
Let’s assume that the current price of BTC against USD is 11,000, and you expect it to rise to 13,000 by the end of this year. The December futures on BTC/USD trades at 12,000. In other words, the market expects the price of BTC/USD to be 12,000 in December. At the expiration of the contract, the futures price will converge with the market price and if your prediction is correct you can cash out the USD 1,000 difference.
In addition to standard futures, the BTC and ETH markets support perpetual futures, which are futures contracts without an expiry date. Since there is no expiry date, both parties can keep their positions open as long as they have sufficient margin.
However, perpetual contracts have no reference date for price convergence, and a separate mechanism is required to ensure price alignment at regular intervals. This mechanism is the funding rate.
The funding rate keeps the price of a perpetual contract in line with the underlying asset’s spot price, discouraging major deviations. Funding rates can be positive or negative – positive rates mean that long position holders must pay short position holders an interest rate equal to the funding rate (usually at 8-hour intervals). In the case of negative rates, shorts pay longs.
Positive funding rates discourage long holders to stick to their position, encouraging them to sell and thereby drive perpetual prices down if they are too high compared to the underlying. The same principle applies vice versa when funding rates are negative.
Funding rates are mean reverting. Significant positive or negative funding rates should lead the payer to close the position and revert rates back to zero. Periods of sustained high funding rates in either direction thus implies a strong directional conviction by the market. If a trader is willing to hold a long position despite a high funding charge, he must be convinced of an upcoming market rally.
Current funding rate situation
In the past week Bitcoin has rallied to a new high for this year. This is mainly fueled by the derivatives market with traders initiating leveraged long positions, which has resulted in the funding rate reaching 12.4 percent/ month – one of the highest levels for this year. This means that long perpetual futures holders require an increase in the Bitcoin price of no less than 12.4 percent per month to be profitable. If we remain at current levels without significant advancements, then it is likely we will see some of these traders reversing their positions and increasing selling pressure.Given the growing significance of the derivatives market, this could lead to a short-term consolidation of the prices. However, there is currently no signs of weakness from the bulls. This is supported by the options market, where there is no indication of an overstretched scenario. The futures market is also priced quite reasonably and given an up-move of roughly USD 2,000 within less than a week.
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