Equilibrium: The Role of the Funding Rate
Last updated
USDN Protocol
Last updated
The Funding Rate is a key mechanism for balancing the USDN Protocol. In practice, the larger side (either the Longs or the USDN Vault) pays a fee called the Funding Rate to the other side. This incentivizes participants to move toward the underrepresented side to collect this payment, thereby naturally bringing the protocol back to equilibrium based on market movements.
To measure each side, as mentioned in the previous section, we use the Trading Exposure of the Long side and the Vault balance.
If the Trading Exposure of the Longs exceeds the Vault balance, the Longs must pay the Funding Rate to the Vault side. Conversely, if the Vault balance exceeds the Trading Exposure of the Longs, it is Vault that pays the Longs.
The imbalance is defined as the relative difference between the two quantities described above, and the Funding Rate is roughly proportional to the square of the imbalance. This means that, as the imbalance increases, the Funding Rate increases faster. This ensures that it gets quickly profitable to enter the underrepresented side in case of imbalance.
In practice, the Funding Rate should not be zero when the protocol is perfectly balanced. This is because the Long positions borrow assets from the Vault and loans generally imply an interest rate. The USDN protocol uses an adaptive mechanism to find the appropriate Skew Factor, which is the value of the Funding Rate when the protocol is perfectly balanced.
This Skew Factor is calculated as an exponential moving average of the daily funding rate and gets added to the part of Funding Rate which is proportional to the imbalance. To simplify the explanations below, the rest of this page assumes that the skew factor is zero.
More information can be found in the USDN Whitepaper.
A positive Funding Rate occurs when the Trading Exposure of the Longs exceeds the Vault balance. This means that the Longs are paying, which happens more often than not when the market for an asset is bullish.
In this situation, Longs make periodic payments to the USDN Vault, generating yield for USDN holders. The greater the imbalance between the Trading Exposure of the Longs and the Vault balance, the more Longs pay in Funding, making the yield more attractive. This then incentivizes new participants to mint USDN to take advantage of these benefits.
By minting new USDN, the Protocol balances itself, as additional assets are added to the Vault, reducing the gap between the Vault balance and the Trading Exposure of the Longs. The Protocol, therefore, naturally rebalances itself through this mechanism.
A negative Funding Rate occurs when the Vault balance is higher than the Trading Exposure of the Longs. In this case, it is the Vault that pays the Longs to open leveraged positions. In other words, traders are paid to take Long positions and borrow assets, which is highly attractive. They can earn money simply by gaining exposure to the price the underlying asset with leverage. In such a scenario, new traders will be incentivized to open Long positions to take advantage of this benefit, thereby increasing the Trading Exposure and rebalancing the Protocol.
However, this is not the only force that drives the Protocol back to equilibrium. A situation with a negative Funding Rate causes a loss for the USDN Vault, as it must pay this funding. Since the value of USDN is directly linked to the Vault, USDN could gradually lose value. USDN holders would then be incentivized to redeem their USDN to avoid losses, which would reduce the Vault balance and also contribute to balancing the Protocol.
The Funding Rate thus plays an essential role in maintaining a balanced Protocol. Whether positive or negative, this mechanism constantly incentivizes participants to adjust their positions, allowing the Protocol to reach equilibrium automatically and organically based on market fluctuations. By offering yield opportunities for both sides (the USDN Vault and the Longs), the Funding Rate contributes to the stability of USDN and enhances its appeal to users.
