Bitcoin Funding Rate - Why it is Essential to Price Stability - Tectum Blockchain

Bitcoin Funding Rate – Why it is Essential to Price Stability

Everyone in DeFi focuses on the price of Bitcoin, but very few people understand the factors that influence the charts. In this article, we will discuss the Bitcoin funding rate – one of the major determinants of BTC prices. The aim is to enable the average person to understand how and why prices change. This is such that they can easily predict the possible changes to the charts.

Meanwhile, this does not mean that people can tell when the next bull run will take place. To enable readers to understand what the BTC funding rate is, we need to examine the futures contracts.

What are Futures Contracts?

Futures contracts are agreements to buy blockchain tokens at a particular price at a specific time in the future. To enable this process, the user enters into a contract with an expiry date when the trade will be settled.

The average user buys tokens via “spot trading,” where the funds are exchanged, and payment is settled almost immediately. Considering that trade immediately, buyers do not hold positions or predict price change.

With futures, traders can choose to sell short or sell long. Selling long means that you are positive that the price of the token will increase, while selling short means predicting a reduction in the value of the cryptocurrency. Instead of actually holding Bitcoin, futures traders borrow it to complete the trade.

If the price of Bitcoin increases, the trader who predicted short settles those who held long positions. Should the value drop, long traders pay those who predicted short.

Conventional futures contracts are usually settled within 1–3 months, where the seller sends assets to the buyer, and the buyer pays for the cryptocurrencies. The major drawback of this form of trade is that the buyer does not have leverage over the transaction.

To solve this problem, centralized crypto exchanges offer perpetual futures contracts that allow traders to settle exchanges at any time. In this regard, they do not need to wait till a specific period to buy or sell tokens.

What is the Bitcoin Funding Rate?

Bitcoin funding rate is the ratio at which people are buying or selling this token. To estimate this figure, crypto exchanges gauge the differences between the derivative contract price and the actual spot price.

Exchanges use a premium index according to the specifications of the futures contract to calculate the BTC funding rate. This process re-occurs every 8 hours at 00:00 UTC, 08:00 UTC, and 16:00 UTC, respectively.

The formula for calculating the Premium Index (P) = {[Max (0, Impact Bid Price – Price Index) – Max (0, Price Index – Impact Ask Price)]} / Price Index

Using the value of the premium index, the exchange increases or reduces the funding rate’s level. This helps to maintain a consistent level for trading futures.

Why the Bitcoin Funding Rate is Important

In the DeFi market, the number of investors holding blockchain tokens determines the price. Having more shareholders means a more significant value of the coin and vice versa.

While conventional futures reduce the rate of price fluctuations, they do not give a significant level of freedom. Considering this factor, most traders typically trade perpetual futures because it allows them to flexibly hold positions and settle trades.

However, allowing investors to settle trade contracts every 8 hours means the charts can also drastically change within this period. All it takes is the next 8 hours for a bull run to change into a bear market and vice versa. Although they are not holding cryptocurrencies directly, their actions greatly impact the price.

The current funding rate determines how Bitcoin prices will move in the coming days, weeks, or months as people often use them as predictors. Investors are more likely to buy more Bitcoin when there is a positive rate. On the other hand, a negative funding rate can cause individuals to sell off their BTC holdings.

While analysts focus on data, the more significant impact is how people respond to the facts. As mentioned above, the BTC funding rate can spur people to take positive or negative investment actions. This factor is also applicable to institutional investors, who most crypto enthusiasts call whales.

For those who do not know what crypto whales are, they are individuals, firms, or institutions that purchase Bitcoin in very large quantities. Their actions are very influential, and news about such acts can trigger significant changes.

A very good example is the announcement of Tesla buying $1.5 billion worth of Bitcoin. While the speculations were ongoing, the price of BTC improved slightly. However, it quickly plummeted when Elon Musk publicly discarded the news of his company adding Bitcoin payment as one of its forms of transactions.

Meanwhile, not every positive rate indicates a positive turn for the markets. There are bear traps that trick people into believing that prices will improve. However, it may just be whales trying to exit the market with a profit. What they do is buy significant Bitcoin and sell their holdings once the price goes up.