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.