Funding rates are a core element of any perpetual swap product, also known as perpetual contracts. Since perpetuals have no fixed expiration date, these contracts can be held indefinitely.

As a result, the typical convergence of a traditional futures price with the underlying asset price as expiration approaches doesn’t apply to perpetuals.

Instead, perpetuals tether the price of the perpetual contract to the underlying asset’s spot price via funding rates. Funding rates modulate the incentive to trade a given perpetual contract, either long or short, by assigning a positive or negative value to a specific perpetual market.

Positive Funding Rate = Perpetual Mark Price > Spot Index Price

Negative Funding Rate = Perpetual Mark Price < Spot Index Price

Funding rates ensure that the mark price of a perpetual doesn't deviate significantly from the underlying index spot price over time.

If the perpetual price is too high relative to the spot index price, longs pay shorts to incentivize short positions, pushing the price back down. If the perpetual price is too low relative to the spot index price, shorts pay longs to incentivize long positions, pushing the price back up.

The funding rate functions like an interest rate paid by open long or short perpetual positions based on current market conditions and how the funding rate is calculated. Funding rates can make holding long or short positions more costly or advantageous over time, depending on their value.

Funding rates are paid or received proportional to the size of an open market position.

Consequently, funding rates replicate the expiration-based convergence of traditional futures and spot prices without an expiration date. Payments on open positions due to funding rates are only exchanged between traders on each side (e.g., long/short) of an individual perpetual market.