How Does the Funding Rate Mechanism Prevent the Perpetual Swap from Trading at a Large Premium Indefinitely?

The Funding Rate mechanism prevents a large, indefinite premium by creating a powerful economic incentive for arbitrage. If the perpetual swap trades at a large premium (above the Index Price), the funding rate becomes highly positive, forcing longs to pay shorts.

This makes shorting the perpetual swap profitable and longing it costly, incentivizing traders to sell the contract, which drives its price down and forces it back toward the Index Price.