This report was provided by a community member. While Synthetix has reviewed the content for veracity, these views are not necessarily endorsed by the Synthetix DAO and/or community.
- Perpetual futures use funding rates to balance short and long positions, which keeps the demand stable for both sides of the derivatives and helps maintain the perp price in line with the underlying spot price.
- Funding rate discrepancies between different trading platforms can create market inefficiencies that present opportunities for arbitrage traders to profit.
- With Synthetix Perps V2 the fees are lower than ever, meaning that traders keep more arbitrage gains.
- Synthetix is at the forefront of developing technology that empowers traders to participate in decentralized trading with minimal trading and transaction fees.
Arbitrage in cryptocurrency trading is a strategy that exploits temporary price discrepancies between different trading platforms. Funding rates, which keep perpetual contract prices aligned with the underlying asset's price, can create market inefficiencies that present opportunities for arbitrage traders to profit. With the efficiencies presented by Synthetix Perps, it's now easier to take advantage of these opportunities. In this article, we'll explore how arbitrage works, the role of funding rates, and how traders can use it to achieve their goals.
What is the funding rate?
Perpetual futures offer traders a unique way to speculate on the future price movements of assets, without the added pressure of expiration dates. Perpetual contracts do not have an expiry. To ensure that short and long positions are balanced, exchanges use the funding rate to incentivize or discourage traders from taking certain positions. This mechanism keeps the demand stable for both sides of the derivatives, which helps maintain the perp price in line with the underlying spot price.
Depending on the traders' positions, they will either pay or receive funding rates. Funding rates will fluctuate as the derivative price deviates in either direction from the underlying asset. For instance, if the funding rate is positive (trading above the underlying asset price), the longs pay the shorts and vice versa.
If the market is a long skew and there are no traders to take the short side, funding rates will continue to tick upwards. If a trader balances skew once the funding rates have increased, the funding rate will stay the same. For example, if the 1hr skew is at +0.01% with 1m long skew and 150k short skew and a trader balances it back down to 0%, it will stay at +0.01% even if a trader brings the market to neutral. If the short skew continues to increase, past the long skew, then the funding rate will decrease.
These unique mechanics in futures trading provide opportunities for traders to exploit funding rate differences between Synthetix Futures (through frontends like Kwenta and Decentrex), through arbitrage. This presents a potentially profitable opportunity for traders looking to capitalize on market inefficiencies.
Understanding funding rate arbitrage.
Typical returns for ETH and other cryptocurrencies offer low yields (4-10%). Funding rate arbitrage offers much higher returns as leverage can amplify returns. Furthermore, with the introduction of Synthetix Perps, the fees are lower than ever, meaning that arbitrage traders can keep more of their profit.
When a position is fully hedged, meaning equal long and short positions for a particular asset, the trader will be completely delta neutral and have no exposure to the cryptocurrency's price. The trader will collect the funding rate difference and profit on the position.
Let's take an example of a potential arbitrage opportunity between Synthetix Perps (via Kwenta’s trading frontend) and DYDX on the LINK-PERP pair. Synthetix and DYDX's funding rates are 0.014361% and 0.002908%, respectively (note: funding rates fluctuate, this isn't current).
As there is such a difference between both funding rates, this is easily exploitable, and traders can profit from the market mispricing. This can be done by placing a short position on Synthetix Perps via Kwenta (funding rate is paid to the trader for holding the position) and a long position on DYDX where the trader pays the short to hold the position. As there is a difference between the funding rates, the trader profits from the difference after all fees.
Let us take a trader that has $20,000 available to execute this trade.
Here's how you would calculate the potential profit opportunity ($20,000 earlier example):
- Funding rate on Synthetix: 0.014361% x 24 x 365 = 125.8%
- Funding rate on DYDX: 0.002908% x 24 * 365 = 25.5%
- Short $LINK on Synthetix: $10,000 (initial capital) x 10x leverage = $100,000 x 125.8%
- Earning a daily funding rate payment of $344.66.
- Long $LINK on DYDX $10,000 (initial capital) x 10x leverage = $100,000 x 25.5%
- Making a daily funding rate payment of $69.79
- Total net revenue totaling $274.87
- Kwenta: $100,000 x 0.08% + $2 = $82 + price impact (based on skew using price impact function)
- DYDX: $100,000 x 0.02% = $20 + price impact (based on available liquidity on DYDX)
- (82+20) x 2 = $204 (for exiting the trade)
Total potential daily profit: $80.87
It’s important to note that this strategy isn’t free of risk. Funding rates can fluctuate as the futures skew changes; hence the trade can become unprofitable depending on the funding rate skew on each exchange. Traders should consider the current open interest when considering such trades, as the funding rate can turn neutral, eroding profitability. Therefore, it is important for traders to monitor open interest levels when opening trades.
When traders take the other side of the trade on another protocol, they need to ensure any price impact of their trade will not deem the trade unprofitable. Hence traders need to be extremely careful using other protocols for taking the other side. Furthermore, there are risks of liquidation, as using high leverage increases the possibility of small price movement causing a liquidation. It is essential to monitor your position to ensure it does not reach the liquidation price, as this may cause significant losses and deem the trade unprofitable.
Lastly, as per all DeFi protocols, smart contract and oracle risk are present as well.
The Cash-and-Carry trade explained
A cash-and-carry trade is a popular strategy traders use to profit from pricing discrepancies in the market. Similar to funding rate arbitrage, it involves taking a long spot position in a token while simultaneously selling the associated perpetual contract. By purchasing the spot version of the token and shorting the perpetual contract, investors can earn the funding rate when the market is long-skewed and shorters are paid to short. Synthetix Perps offers traders an efficient way to execute cash-and-carry trades without worrying about high fees.
When the market is heavily skewed in one direction, traders can profit from asset mispricings. They can do this by taking the opposite position and purchasing an equivalent amount of spot tokens. This allows them to benefit from the price discrepancy caused by the long skew. Once the market returns to a more balanced state, the trader can sell their position and realize their profit by closing both positions.
What is Synthetix Perps?
With the recent introduction of Synthetix Perps upgrade Perps V2, trading perpetuals has become easier and more accessible. Synthetix now offers traders the advantage of lower fees, with trading fees reduced to only 5-10 basis points. This makes Synthetix Perps one of the most capital efficent places to trade perpetual contracts, enabling traders to capitalize on arbitrage opportunities.
SNX has also made significant strides to minimize the risk that perps LP's (stakers) take on through innovative risk management features. That's why dynamic funding rates and a price impact function have been introduced.
The price impact function incentivizes arbitrage traders with a price discount given to traders who return markets to neutral skew. Dynamic funding rates allow funding rates to drift upwards in the presence of continued imbalance, incentivizing arbitrage traders to step in.
Both functions will introduce arbitrage opportunities for traders to keep markets neutral over the long term. This innovative path to risk management will help increase scalability and capital efficiency while supporting a wider range of markets.
Platforms like Kwenta and Decentrex offer a clean and intuitive user interface for trading Synthetix Perps. This ease of use makes it simpler for traders to navigate the platform and identify potentially profitable trading opportunities. Whether you're an experienced trader or just starting in cryptocurrency trading, the low fees and user-friendly interfaces of Synthetix Perps trading front-ends make it an attractive platform for traders seeking to use various arbitrage strategies.