Basics of Futures Funding on Kwenta
March 3rd, 2023

In light of the numerous inquiries surrounding the funding rate and premium/discount mechanism on Kwenta, we have compiled an educational blog that aims to address these topics in a comprehensive manner.

🔸The basics of funding
🔸Common strategies
🔸Kwenta's unique mechanism
🔸Additional resources

What is funding?

Funding can be likened to an interest payment in that it represents a percentage of your position size, after taking into account the impact of leverage, that is paid or received at regular intervals. When funding is positive, those with long positions pay those with short positions, whereas when funding is negative, those with short positions pay those with long positions.

Why does funding exist?

Funding exists because sometimes it's more attractive to hold one side of a trade. For every long, someone must be short. On Kwenta, Synthetix stakers take the other side of every trade. Funding rates attract traders on each side, balancing the skew.

What are the risks?

Funding reduces the profitability of a trade and increases the risk of liquidation. For example, hourly funding of 0.01% is about 87% annualized. With liquidation buffers and fees, traders could be liquidated in about a year, even if the price remains flat. By using leverage, this risk is compounded. Since funding is charged on notional position size, the impact on your collateral is directly proportional to your leverage.

For example, 100% annualized funding at 2x will liquidate traders in under 6 months. At 25x, about 2 weeks.

What are the advantages?

Just as traders pay funding, those on the opposite side of the trade collect funding. This can be a boost to PnL on directional positions or used as part of a more complex strategy. Common strategies include basis trading and funding rate arbitrage. These common strategies are Delta Neutral -- meaning short and long exposure is balanced.

In basis trading, a trader shorts positive funding and collects spot. In funding rate arbitrage, two perps positions are taken on different exchanges. Just as leverage increases the risks of funding, leverage also allows traders to increase their exposure to gains from funding payments.

How does funding work on Kwenta?

On Kwenta, funding is not directly proportional to skew, but instead, skew is used to calculate funding rate velocity.

📈 If the skew is long, funding goes up.

📉 If the skew is short, funding goes down.

⚖️ If the skew is neutral, funding stays the same.

This means that if the skew moves rapidly due to large traders entering and exiting, funding does not immediately change but will change over time if the skew remains. This also means some assets may settle and persistently positive or negative funding, even if the skew is neutral.

Why would Kwenta want this?

"Fair market" funding on assets is rarely zero. If the market is extremely bullish, "fair" funding may be positive. If an asset has high inflation, "fair" funding may be negative. Kwenta ensures "fair" pricing for both sides of the trade.

By creating a market for funding, Kwenta can find the point where longs and shorts are equally incentivized to take positions, balancing OI. This means higher OI caps and more assets without increased risk to liquidity providers, protecting system integrity.

Kwenta includes a premium or discount, which is directly proportional to the skew. Premium serves 2 functions.

🔸 Premium is the basis for price impact, which simulates order book liquidity. By simulating liquidity, Kwenta can accommodate large trades or lower liquidity assets.
🔸 Premium provides added incentive for arbitrage traders, ensuring that OI is balanced and funding rate arbitrage remains attractive.

Since this price impact is persistent, it makes no difference whether demand comes from a single trader, or many traders.

Although this system is experimental, early results are promising. Skew on Kwenta is frequently neutral, resulting in low risk for LPs. This low risk should translate to future OI cap increases and additional asset listings without introducing significant systemic risk.

Want more resources? We know this mechanism is an overwhelming topic, but we're here to help!

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