The funding rate is how the price of a perpetual swap is kept close to the price of the underlying asset. It works by sending periodic payments between long and short traders. This is critical: a poorly designed funding rate makes perpetual swaps riskier, more volatile, and more costly.
The funding rate enables a perpetual swap to closely track its underlying by balancing supply and demand between the buy (long) and sell (short) sides of the market. The funding rate is similar to either a fee or a rebate, that traders pay or are paid to hold their positions, depending on which side of the market they are on.
On BitMEX, for example, if the BTC/USD perpetual swap (XBTUSD) is trading above the spot price of Bitcoin, the funding rate would be positive. This means that long traders would pay short traders (discouraging long positions and incentivizing short positions). On the other hand, if the BTC/USD perpetual swap is trading below the spot price of Bitcoin, the funding rate would be negative. This means that short traders would pay long traders (discouraging short positions and encouraging long positions, thus raising the perpetual swap’s price up towards the underlying).
These instruments fundamentally stay in line by balancing supply and demand via a funding rate mechanism. If the price of the perpetual swap is close to spot price it’s tracking, the funding rate transfer is small to bring it back into line. The farther off it gets, the higher these payments will be. Funding rate fees are a function of the notional position size (regardless of leverage), so can have a significant impact on traders, especially those who are highly-leveraged.