How Does the Funding Rate Mechanism Work in a Perpetual Swap?

The funding rate is a small, periodic payment exchanged directly between traders holding long and short positions in a perpetual swap contract. If the contract price is trading above the underlying asset's spot price, the funding rate is positive, and long position holders pay short position holders.

If the contract price is below the spot price, the rate is negative, and shorts pay longs. This payment incentivizes arbitrageurs to push the contract price back towards the spot price, keeping the derivative anchored to the underlying asset's value without an expiration date.