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What is the purpose of AAX’s funding mechanism?

What is the purpose of AAX’s funding mechanism?

Explainers AAX

07 Oct 2019

In addition to OTC and spot, AAX’s platform enables investors to trade futures. Specifically, perpetual futures contracts. As some of you may know, when you hold a position in AAX’s futures market, you automatically take part in our funding program. This is a mechanism that tethers the futures market to the price of the underlying asset across multiple spot markets and facilitates true price discovery.

In this post, we aim to explain how this mechanism works.

What are perpetual futures contracts?

Perpetual futures contracts belong to the family of financial instruments best known as derivatives. Unlike conventional futures, a perpetual futures contract never expires.

With conventional futures, you agree to buy a certain asset at an agreed price at a specific time in the future. But with perpetual contracts, it’s more about investing in an expectation: if you think the price of an asset will go up, you go long; and if you expect the price to go down, you go short. If you are correct and close your position in time, you can make a profit.

Technical indicators can help you forecast which direction the market will go, with popular indicators being ATR, CCI, Elliot Wave, Stochastic and Inside Bar Breakout.

Why is there a funding mechanism?

Price movements in the futures market are not meant to be baseless or merely follow the whims of speculators. Ultimately, the price of a derivative should be derived from the underlying asset, which in practice means there should be a close correlation between the futures market and the actual price of the asset as observed across multiple spot markets - i.e. an index.

But since there is no settlement, technically, there is nothing that is keeping such correlation intact. For this reason, we have put a funding mechanism in place which links the perpetual futures contracts market to the underlying asset, incentivizes traders to adjust their positions accordingly, and drives price convergence.

How does the funding mechanism work?

AAX’s funding mechanism consists of two parts, each designed to optimize price discovery and ensure the futures market follows the index more closely.

Every 8 hours, all traders who hold perpetual futures contracts will either receive or pay a funding fee - this is an automatic process. If a contract is trading at a premium, meaning contracts are too expensive compared to the actual price of the underlying asset, the longs will pay the shorts. Vice versa, if contracts are trading at a discount, shorts will have to pay longs. A similar process takes place to balance interest rates.

Remember: Longs are expecting the price of an asset to go up. If the market is somewhat overbought and they have to pay the shorts, in order to avoid such payment they can choose to close their position. This drives the price down, closer to the actual price of the asset. This works the other way around as well.

Why is it important to have a funding mechanism in place?

Ensuring the close connection between the perpetual futures market and the index is vital as it guards market integrity and fosters true price discovery. The funding scheme is a way to correct deviations as it creates an incentive for those trading futures to adjust their positions to price movements on the actual spot markets.

The reason why we track multiple spot markets, taking into account order volume, market depth, and trade size, is to prevent potential market manipulation in one market from distorting the futures market.

If you want to learn more about futures trading on AAX, we encourage you to study our Futures Guide for Beginners.

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