Ethereum Market Chaos After Merger

Trends of the Week

As selling pressure increases and miners leave, the price of ETHW (Ethereum's forked token) plummets.

Ethereum’s Proof-of-Work has had a rocky start. ETHW, the token representing the new hard-forked Ethereum network, has fallen more than 80% since listing on FTX. The network’s overall poor launch was further exacerbated by glitches and the emergence of a competing fork called EthereumFair, which is backed by the exchange Poloniex.

Meanwhile, the Ethereum network, one of the first to hard fork, has seen a surge in hash rate as miners transition to mining ETC following a successful merger. Ethereum Classic forked in 2016 but has failed to gain significant market share or usage over the years. ETC is down 25% this week and has very poor liquidity on centralized exchanges, which could cause problems for new miners looking to cash out.

If miners sell their ETC on the spot market, they will see nearly 5 times the drop on a $100,000 market sell order as they would if they sold ETH. This additional cost is the next in a series of problems facing ETH miners in the future as they strive to stay relevant and, most importantly, profitable.

1. Price Changes

Post-merger sell-off sweeps markets

In what many expected to be a positive week for Ether prices, a successful consolidation capped a week of sharp sell-offs of around 25%. ETHW and ETC were also the week’s worst performers, suggesting that established Ethereum miners will struggle to remain profitable. In broader industry news, a South Korean court issued an arrest warrant for Terra founder Do Kwon, the Blockchain Association formed an industry PAC, and Wall Street firms Charles Schwab, Citadel Securities, and Fidelity Digital Assets announced the launch of a new cryptocurrency exchange, EDX Markets.

ETH discount rate narrows to lowest level since May

The discount of staked ETH tokens relative to spot ETH has narrowed to the lowest level since May, a trend that first emerged hours after the Ethereum network successfully transitioned to proof-of-stake. Liquid staking derivative tokens such as Coinbase's cbETH, Binance's bETH, and Lido's stETH are wrapped versions of ether staked on the Ethereum consensus layer (Beacon chain). They are not pegged to ETH, and their market price takes into account some regulatory and smart contract risks. For example, if the validator node involves being "punished" by the Ethereum network in the event of a problem with the validator node, then these tokens that involve the punished part of the Ethereum staking node may be at risk.

Lido’s stETH discount narrowed significantly from 4% to just 1%, helped by increased liquidity in Curve’s stETH pool, the largest secondary market for staked ETH. The cbETH and bETH markets also saw strong buying pressure immediately after the merger (we discuss the market reaction to the merger here). While this trend suggests that some risk premium has been removed, the staked ETH discount may continue until the next Ethereum upgrade next year allows for staked withdrawals. However, the opportunity cost of holding ETH is now increased (because staking provides additional yield), which may provide some favorable factors for staking ETH markets.

2. Market Liquidity

The US dollar remains the dominant fiat currency among cryptocurrencies

While most cryptocurrency transactions are currently conducted using stablecoins, fiat currencies remain a key channel for entering and exiting the market. Historically, the U.S. dollar has been the most important fiat currency in cryptocurrency, but how has its role changed over time? Since 2018, the share of Bitcoin traded against the U.S. dollar has increased significantly, and the U.S. dollar currently accounts for more than 70% of Bitcoin trading volume.

This trend can be explained by the increasing institutionalization of the market, as large investors generally prefer to trade in US dollars. However, a closer look at the breakdown by fiat currency shows that local regulation may also play a role. It is worth noting that Bitcoin trading volume in the Japanese market has fallen sharply. After suffering a $97 million hack and stricter regulation in Japan, the annual trading volume of Japanese exchange Liquid fell fivefold between 2018 and 2021. In contrast, Bitcoin trading volume in the US dollar market increased by 30% during the same period.

As regulatory regimes around the world become clearer, the market share of stablecoins may continue to develop. For example, Japan is reportedly considering relaxing regulations on the review of new assets. For now, the US dollar remains the hegemon.

ETH market share hits all-time high during post-merger sell-off

The market share of Ethereum trading volume reached an all-time high during last week's post-merger sell-off, approaching 70% of Bitcoin's trading volume. The massive liquidation of leveraged long positions in the derivatives market exacerbated the decline in spot prices, causing a surge in spot trading volume. Overall, ETH's market share has more than tripled since 2020, indicating that the market structure is shifting away from BTC and toward another market.

As volume surged, liquidity in the ETH spot market evaporated, measured by the volume of bids and offers within 2% of the mid-price in the ETH-USD (T) order book. This suggests that market makers were nervous and reduced liquidity to avoid being caught in the volatility associated with the merger. Liquidity quickly increased after the merger and is now only slightly above pre-merger levels.

While Ethereum continues to perform slightly weaker than Bitcoin YTD (year to date), its expected decline in issuance may provide support for its price despite the challenging macro environment.

Binance changes the trend in trading volume

Trading volume is one of the best indicators of a prolonged bear market. The initial price slide is usually accompanied by a surge in trading volume as traders take advantage of (or suffer from) the volatility. However, as days turn into weeks, which turn into months of depressed prices, trading volume on most exchanges begins to decline. However, when looking at the aggregated volume of the most liquid BTC and ETH pairs, we can observe no such trend since the beginning of the bear market in May. While weekly trading volume is still well below all-time highs, there has actually been a slight uptick in activity over the past few months.

Unfortunately, aggregate data can obfuscate exchange-level trends. When separating Binance from this aggregated dataset, we can see a large disparity in activity between the world's largest exchange and the other 13 exchanges. Volume for the Bitcoin/ETH pair has surged since Binance eliminated trading fees on the pair. For the first time, Binance's market share far exceeds the combined volume of the other 13 exchanges (including Coinbase, FTX, Huobi, Okex, and others). Since the beginning of 2022, volume has actually trended downward for all exchanges except Binance, in line with our expectations for a bear market.

Removing trading fees on the most liquid currency pairs is not something most exchanges can afford, so we can probably expect this trend to continue until the market corrects.

3. Derivatives

ATOM open interest surges amid bullish market

In a few months of sluggish cryptocurrency prices, Cosmos’ ATOM token has been one of the few bright spots. Cosmos is a decentralized network of independent and interoperable blockchains that aims to become the “internet of blockchains,” enabling them to share data and tokens across their ecosystems.

ATOM has gained over 40% in the past four days, even though the token is down 54% year to date (competitors like SOL and AVAX are down 82% and 85%, respectively). After the collapse of Terra, which was part of the Cosmos ecosystem, development of a number of other projects has begun to take over its activity, including Kava, Osmosis, and Thorchain. Additionally, it is widely expected that the team will soon announce new tokenomics for ATOM, which will reduce inflation and increase the utility of the token. Amid these positive catalysts, open interest has surged from less than $50 million in mid-June to over $200 million today. The average funding rate has been trending upward since the beginning of September, suggesting that the recent surge in open interest is biased in favor of longs.

ETH financing rate rebounded sharply

As the ETHW airdrop began, the ETH funding rate rose sharply from its post-merger historical lows, and futures prices no longer needed to account for potential arbitrage. Investors took advantage of the ETHW airdrop by combining their ETH spot long position with their ETH futures short, eliminating price risk while still being able to collect the ETHW airdrop. This strategy would also profit on the futures short trade if the futures price was not discounted to reflect this strategy. Once the merger was successfully completed and the ETHW airdrop occurred, futures returned to close to spot prices, so the funding rate once again moved sharply toward neutral.

4. Macro trends

Higher-than-expected U.S. inflation raises bets on Fed rate hikes

Macroeconomic headwinds continue to weigh on financial markets. Earlier, higher-than-expected U.S. inflation in August sent cryptocurrencies and stocks tumbling. Headline inflation rose 8.3% year-over-year, slightly below July's reading. However, monthly core inflation rose 0.6%, almost double expectations. Core inflation excludes volatile food and energy prices and is considered stickier and more costly to hedge than headline and energy inflation. Concerned that the process of reducing inflation will be slower and more painful than expected, the Fed has made a sharp adjustment to its top interest rate, which is currently above 4%. The Fed is widely expected to make another sharp 75 basis point rate hike at this week's meeting, while bets are increasing that the Fed will do so.

Bitcoin's correlation with bonds, stocks rises in September

Bitcoin's correlation with bonds and stocks resumed its upward trend in September after falling over the summer. Uncertainty about inflation coupled with the Fed's tightening policy has led to historic declines in both risk and fixed income assets, challenging traditional approaches to asset allocation. The iShares Aggregate Bonds ETF, which tracks the U.S. investment-grade bond market, is down 12% year to date, the Nasdaq 100 is down 28%, and Bitcoin is down more than 50%. Recent research suggests that persistently high and more volatile core inflation may be one explanation for the positive correlation between bonds and risk assets over the past few months, as inflation has a negative impact on all asset classes.