Horizon Futures: Price Impact Function and Dynamic Funding Rates
Normally, a perpetual futures contract will have two counterparties, one long and one short, where the two counterparties pay each other on an ongoing basis depending on whether the market price of the underlying asset is higher or lower than the contract price.
Because Horizon Futures is a decentralized perpetual futures platform that leverages Horizon Protocol’s staked liquidity as the counterparty of all open positions, the stakers are the ones who either pay or receive the ongoing funding payments when the contract price is higher or lower than the market price.
To incentivize these markets towards a balanced skew between longs and shorts, also known as delta neutrality, Horizon Futures implements a 2-layer approach rather than rely on a single mechanism. The 2 mechanisms are:
- Price impact function and
- Dynamic funding rate
In the following article, we explain the importance of maintaining delta neutrality in perpetual futures and provide details and examples of the two mechanisms implemented to maintain delta neutrality.
Delta Neutrality
Delta neutral is a term used in traditional finance that describes a portfolio strategy that balances the positive and negative deltas, also known as “change over time”, so that the overall delta of the assets in question totals zero. Essentially, delta neutrality is achieved if the market’s base-unit size of all open longs and shorts are equal to each other which establishes a net change of zero regardless of how the asset’s price changes.
Perpetual futures, unlike traditional futures, have no expiry date, and traders can hold their positions indefinitely as long as they maintain sufficient margin. Since there is no expiration date, perpetual delta neutrality mechanisms are required to drive the futures contract price back towards the spot market price. Maintaining delta neutrality lowers the risk from market imbalances for the stakers in the Horizon Protocol ecosystem, who provide the collateral and liquidity that are used as the counterparty of all positions in the perpetual futures platform.
Without delta neutrality and mechanisms that drive neutrality, a perpetually unbalanced futures market could result in zUSD minted at the expense of the debt pool and the stakers who collateralize it.
Horizon Protocol’s liquidity is designed to facilitate the ease of use for Horizon Futures by offering liquidity to smooth out the process and allow for instantaneous transactions instead of waiting for a perfectly aligned counterparty. Delta neutrality incentives are absolutely critical to the security of Horizon Protocol’s liquidity.
Price Impact Function
The first of the two delta neutrality algorithmic mechanisms is the Price Impact function. The price impact function influences the price of the futures contract, which occurs at the time of any futures contract transaction.
The price impact function encourages market neutrality by offering price discounts for traders to take trades that reduce the market skew and premiums for traders who increase the market skew. When there’s a long skew, where there are more traders with long positions than short positions, traders going short will earn a discount on the fill price of their trade based on how imbalanced the skew is. A larger skew will result in a larger premium or discount. If the same trader executes a long trade when there is a long skew, the trader will pay a premium on their fill price. Conversely, when there’s a short skew, traders going long receive a discount, and those going short pay a premium. This mechanism rewards traders to take positions that help reduce the skew and balance the market, promoting stability and reducing risk for stakers.
The Price Impact function is the first layer of incentives that helps protect stakers by ensuring that there are multiple structures that keep markets delta-neutral for liquidity providers. The price impact function mechanism actually creates a high-frequency rebalancing incentive where delta-neutral arbitrage can take place, and places soft limits on the maximum exposure held by the debt pool by storing premiums from takers, who are increasing the skew, and distributing them to makers, who are decreasing the skew. This mechanism reduces the likelihood of non-neutral markets and all of this is algorithmically driven and is achieved without needing explicit restrictive open interest limits and mitigating challenges related to decentralized oracle latency.
Dynamic Funding Rates
The second layer of the delta neutrality algorithmic mechanisms is dynamic funding rates. The funding rate is a mechanism that ensures that the price of the perpetual futures contract stays close to the spot price of the underlying asset.
As mentioned at the very beginning of this article, a Horizon Protocol perpetual futures contract has ongoing funding payments on all open long and short positions depending on whether the market price of the underlying asset is higher or lower than the contract price. This payment is the funding rate.
The funding rate fluctuates based on the deviation between the futures contract price and the market price of the underlying asset, which is ultimately driven by the market skew and the price impact function. When the price of the futures contract is higher than the price of the underlying asset’s market price, the long side pays the funding rate and the short side earns the funding rate because the market is skewed long, which means the size of all open longs is greater than the size of all open shorts. When the price of the contract is lower than the underlying asset’s market price, the short side pays the long side because the market is skewed to the short side.
Dynamic funding rates are not instantaneously calculated based on the current market skew but are instead derived from a zero-sum velocity-based model. The funding rates will change continually over-time based on the velocity rate that is derived by the current market skew. A long skew will mean the velocity will increase and the funding rate will therefore increase continuously over time at a rate proportional to the skew size until it reaches a maximum funding rate, or if the market skew is corrected or reversed. This velocity-based method smooths the funding rate, creating less instantaneous funding rate volatility for an improved UX and a more natural rate discovery. The funding rate itself is a 24-hour rolling basis rate.
Although Horizon Protocol stakers are either the payer or beneficiary of funding on every position opened, the funding flows through stakers will always reach a net funding rate earned of zero over time as the market eventually corrects itself. No funding is paid to either side if the market has achieved delta neutrality.
Dynamic Funding Rate Simplified Example
Let us assume that the BNB perpetual futures market currently has $100,000 in LONG positions and $20,000 in SHORT positions.
Three scenarios can happen for this market from here:
- Skew stays long — No one enters (or exits) this market. Funding rates will continue drifting upwards. Longs pay shorts an increasing amount over time until it hits the maximum dynamic funding rate according to the formula. If the long skew increases with additional long positions, then the drift upwards will increase in speed.
- Skew becomes neutral — Traders bring the skew to neutral (100,000 LONG and 100,000 SHORT.) Funding rates will decrease towards 0.
- Skew flips to short — Traders flip the skew to SHORT (50,000 LONG and 100,000 SHORT.) Funding rates will decrease past 0 and flip to the other side. Longs pay shorts a decreasing amount each over time it flips and shorts pay longs an increasing amount until it hits the maximum dynamic funding rate according to the formula.
Visualizing Price Impact and Dynamic Funding Rate in Horizon Futures
Both the Price Impact function and the Dynamic Funding Rate will be visualized and displayed to users in Horizon Futures.
You can find Price Impact highlighted when you are entering into a position for a futures contract.
And you will find the net Dynamic Funding value under the position history
In conclusion, the mechanisms of the Price Impact Function and Dynamic Funding Rates within Horizon Futures demonstrate a commitment to market stability and risk mitigation. These innovative mechanisms ensure a balanced market skew, promoting delta neutrality and aligning perpetual futures contract prices with the spot market. By incentivizing actions that reduce skew and providing continuous rate adjustments based on market dynamics, Horizon Protocol fosters a secure and efficient ecosystem for traders and stakeholders. The transparency and functionality of these mechanisms empower users, facilitating informed decision-making and ensuring a resilient and sustainable futures trading platform.
Horizon Protocol is a DeFi platform that facilitates the on-chain trading of synthetic assets that represent the real economy. Horizon Protocol seeks to provide exposure to real-world assets risk/return profiles via smart contracts on the blockchain.
