Funding rates are high, when speculative demand is high, and subsequent returns are--on average--lower. But why is that?

Thread on perpetual swap funding rates explaining (a) why it swings so much (b) how it predicts returns (including a backtest). https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3774118

1/7: The funding rate of perpetual swap, e.g. on BitMEX, did swing from +30bp to -37.5bp for an 8-hour interval since 2019. High rates also mean high 'riskless' carry/arbitrage profits. In an arbitrage-free world, the rate should be stable. But it is not. Why?

2/7: In "normal" times, the funding rate, aka the basis, aka the carry, averages ~8% annualized. This is true for the 8-hour perpetual swap rate and longer-term futures. In the current bullrun, the basis for the BTC/USD June future on OKEx is at ~8.3%.

3/7: An arbitrageur can deposit 1 BTC to OKEx, short 1 BTC in the BTC/USD future, and earn "riskless" 8% from now till June. Why so much compared to FIAT rates? Because demand pushes rates higher in bull-runs, exchanges still carry default-risk, and arbitrage capital is scarce.

4/7: Centralized trading is spread across various exchanges (and instruments), each requires separate collateral/margin. Thus, capital requirements for arbitrageurs are huge compared to FIAT arbitrageurs who can pool/net positions across exchanges via prime brokerage.

5/7: In a bullrun, speculative demand outweighs arbitrage capital and the funding rates rises. The research note shows that this is similar to a fear-and-greed index whereby high (low) funding resembles greed (fear). For example, the recent Musk's bio change:

6/7 Looking at data from 2019-2021, the article finds that the funding rate predicts BTC/USD returns best when it is at the extremes, e.g. in the 10- or 90-percentile.

7/7: The funding rates also works across coins. Here, the article creates portfolios of perpetual swaps and buys (sells) coins with low (high) funding rate.