Funding Fee Risk
Given Multipli uses derivatives positions, such as perpetual contracts, to hedge the delta of the digital asset collateral, the protocol is exposed to "Funding Risk." Funding risk relates to the potential of persistently negative funding rates. Multipli can earn a yield from funding but may also be required to pay funding.
While this is a direct risk to the protocol yield, the data presented below demonstrates the mitigation techniques used by Multipli. Negative funding rates are a feature, rather than a bug, of the system.
Mitigating Funding Risk
When funding rates turn negative, long traders pay short traders, which can erode profits for those holding short positions. To prevent such cases, we combine our funding rate strategy with contango.
Exploiting Contango:
In a contango market, traders can lock in profits by selling futures contracts at higher prices while holding the underlying asset at lower spot prices. As the futures contract approaches its expiration, its price converges with the spot price, allowing traders to realise the price difference as profit.
This locked-in profit from contango serves as a hedge against potential negative funding rates.
For instance, if a trader has locked in a profit of $100 from contango and faces a negative funding payment of $50, the net effect is still a positive profit of $50. This reduces the impact of negative funding rates on the overall returns.
Advantages of Combining Strategy
Enhanced Profitability:
The dual income streams from positive funding rates and locked-in contango profits create a more stable and enhanced profitability profile. This diversification of revenue sources reduces reliance on a single market condition.
Robust Risk Management:
The strategy effectively hedges against the risk of negative funding rates by using the profits from contango to absorb potential losses. This balanced approach ensures that traders are not overly exposed to adverse funding rate movements.
The delta-neutral positioning further stabilises the portfolio by mitigating directional risks associated with price movements of the underlying asset.
Market Efficiency and Arbitrage:
This integrated approach exploits market inefficiencies, contributing to price alignment between perpetual futures and traditional futures markets. By engaging in arbitrage activities, traders help to maintain market balance and reduce excessive premiums or discounts.
The strategy encourages a more efficient market where price discrepancies are minimised, benefiting the broader trading ecosystem.
Consistency in Returns:
The combination of funding rates and contango provides a more consistent return profile. While funding rates can be volatile, the predictable nature of contango profits offers a stabilising effect on overall earnings.
This consistency is particularly valuable in the highly volatile crypto markets, where traders seek reliable income streams.
Back-testing Insights
To assess the impact of this risk, we conducted extensive back-testing of our spot-perpetual funding rate arbitrage strategy over the past four years. The findings indicate that, even during bearish market conditions, the funding rate has consistently rebounded to positive values, ensuring the strategy remains profitable.
Back-testing Highlights:
Average Annual Return:
The average annual return of the strategy is approximately 14.78%. This demonstrates the strategy's ability to generate significant yields over the long term.
Resilience During Bearish Markets:
Historical data shows that even during extreme bearish markets, the funding rate has bounced back to positive values. This resilience indicates that the risk of prolonged negative funding rates is mitigated.
Percentage of Positive Funding Rates:
The funding rate has been positive approximately 87.70% of the time. This high percentage suggests that negative funding periods are relatively infrequent and short-lived.
Example: Performance of our strategy during Bear Market
During a significant bearish market phase in 2022, the funding rate briefly turned negative. However, within a few days, the rate bounced back to positive territory, allowing the strategy to recover and continue generating yields. This pattern was observed consistently across different market cycles, reinforcing the strategy's robustness.
Conclusion
Although extended negative funding rates pose a potential risk, our back-testing data and contango arbitrage trading strategy demonstrate that this risk is manageable. With an average annual return of approximately 15% and a high percentage of positive funding rates, the strategy consistently proves profitable over the long term.
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