With the merger imminent, the derivatives market has become the "main battlefield" to promote the direction of ETH

The Perpetual Futures market is a battleground for institutions, risk hedgers, and speculators. During the 2021 bull run, Perpetual Futures became one of the main catalysts for all-time highs as new money poured into the market with excessive leverage. Fast forward to September 2022, and we see this new money returning to the Perpetual Futures market with more ferocity than ever before, especially for ETH, where open interest recently hit a new all-time high, just before one of the biggest catalysts in the crypto market – the Ethereum merger.

This article will break down the nature of the positions that the derivatives markets took prior to the merger and what that means for the price of ETH in the short and long term. The article will take a data-driven approach to analyzing whether both the spot and futures markets are the main forces behind the current price of ETH.

All eyes on ETH

As the Ethereum network approaches a defining moment in its short history, ETH investors are understandably anxious and excited in equal measure. Skeptics liken the merger to “changing an airplane engine mid-flight,” while bulls are hailing the transition as a game-changer for Ethereum adoption. This divergence of opinion paves the way for increased volume in the ETH perpetual futures market, as investors on both sides of the debate look to position themselves accordingly ahead of the merger.

We’ve already seen this in the share of perpetual futures volume between BTC and ETH, with ETH increasing from accounting for 45% of volume at the beginning of the month to 57% at the end of August as the merger approached.

New money pouring in

I mentioned that as we approach the merger, money is moving into the futures market more aggressively than ever before. Open interest is a measure of how many open positions there are at the time, representing the amount of capital currently invested in futures. In my opinion, it is important to look at open interest in the native unit of the asset (i.e. denominated in ETH) because open interest denominated in USD has a price effect. As shown below, open interest in USD closely tracks price and is often a poor indicator of capital flows in futures markets.

What we don’t see here is the massive amount of new positions that have been entered over the past month or two as the consolidation looms. Open interest denominated in ETH shows us that the number of open futures positions is at an incredible all-time high at this time, providing huge leverage to ETH’s price action over the next few weeks.

Funding Rate

Funding rates bring perpetual contracts closer to the index they track. If demand for long futures contracts increases, the funding rate will be positive, and those holding long positions pay shorts to incentivize balance between positions. However, oftentimes, sentiment is so imbalanced that funding rates can persist, either positive or negative. Since the 2021 bull run, funding rates have hovered below neutral as negative sentiment seeped into the futures market.

Interestingly, regarding ETH, the funding rate has fallen significantly towards the end of August as we approach the consolidation. This decline in negative values ​​coincides with the increase in open interest, leading us to conclude that most of the new money pouring into the ETH futures market is short.

There are several reasons why investors might short ETH futures ahead of a merger:

• The first is a naked short position against ETH, betting on an unsuccessful or delayed transition to proof-of-stake. This might not be a bad option based on the fact that the previous merge date was pushed back a few times, but it is looking more and more likely as the day comes when the merge will go ahead, especially after all testnets have transitioned smoothly. I find it hard to believe that investors would be nakedly shorting ETH ahead of such a potential catalytic event.
  

• The second reason, which seems more likely to me, is that this is a case of investors hedging their long spot ETH positions ahead of a merger. Hedging long ETH positions allows investors to hedge some risk ahead of an event that could theoretically be pear-shaped. A strategy that also involves shorting ETH futures is to go long spot ETH, short futures, and make yourself eligible for any ETHPOW (ETH Proof of Work) airdrops. Think of this as a dividend strategy, eliminating any price risk by going long spot and short futures, but collecting potential dividends in ETHPOW.

If the merge goes through, and the Proof of Work chain fork fails to launch, we should see a lot of these short ETH positions get liquidated.

When the majority of an asset’s daily volume is in the futures market (as we’ll see later), the liquidation of shorts should be positive for the asset’s price. When you combine these liquidated shorts with the ~$40 million in daily miner selling that has been reduced due to the move to proof-of-stake, the short-term and long-term outlook for ETH can be quite bullish as two huge selling pressures are being lifted.

As we can see below, the negative funding rate caused by short positions accompanied ETH's decline from the $2,000 level and moved in sync with price. If these shorts are closed after the consolidation, then the ETH funding rate could move towards positive territory, which would certainly help price sentiment.

Spot and perpetual contract trading volume

We have seen negative funding rates and increases in open interest coincide with ETH falling over 30% from this month’s highs. This begs the question, how much influence does the perpetual contract market have on crypto prices? This is a question of price discovery, and it really comes down to which market is currently leading price discovery, spot or perpetual futures? One way to do this is to look at volume - volume often correlates with price movement, and if futures markets are seeing greater volume growth than spot markets, we might determine that futures markets are leading price discovery.

Looking at the daily trading volume of ETH perpetual contracts last year, we can see a significant increase from $19 billion to over $33 billion. At the same time, daily spot trading volume increased from $3.7 billion to $4.8 billion in a little over a year.

Breaking these volumes down into a ratio to assess movement relative to each other, we can see that ETH perpetual futures volume dominance is increasing as the ratio of perpetual contracts to spot volume increases from 5x volume to roughly 7x.

The increasing number of perpetual futures trading relative to the spot market is starting to have a huge impact on the sentiment around ETH. When the market was at an all-time high last November, perps were trading at only 4x the spot market. Now with 7x the volume and open interest at an all-time high, it seems that investors and institutions are turning to perpetual futures to bet on ETH, with a predominantly short bias as we have seen over the last month.

Options Market

The same trend we saw in the perpetual futures or risk hedging of ETH short positions before the merger is also reflected in the options market. Put buyers [Put = an option to sell an asset at an agreed price, usually seen as a bearish bet] seek to lock in a price level below which they will stop losses. This is evident when looking at the volume between the $1000-2000 strike price level for ETH options expiring before the merger, as the 3 highest volume strikes are $1600, $1500 and $1400, with put options at the latter two strikes dominating.

$1,700 is the first strike price we observe where call volume exceeds put volume, suggesting that options investors are no longer concerned about negative price risk and are instead seeking any upside in call options.

When people think of crypto options, they think of speculative long positions, but the volume of pre-merger options is arguably the clearest example of risk hedging that the crypto options market has seen. For options expiring before the merger, the put/call volume ratio was actually split down the middle, which is rare for crypto options. However, after the merger, the split returned to 73% in favor of call options as speculative investors dominated and bet on a successful merger.

ETH’s options market is probably the best insight into investor sentiment in the two weeks leading up to the merger. In short, investors were nervous about the event, hedging their bets and limiting their speculative behavior. After the merger, investors seemed reluctant to go short because the likelihood of positive price action in the short term was high as the aforementioned selling pressure was removed.

in conclusion

With perpetual futures volumes rising in dominance relative to spot markets, derivatives markets are currently having a huge impact on price action. Nowhere is this more important than ETH, which is facing a huge, volatility-inducing event in a consolidation in a few weeks — and futures markets are tailor-made for high-volatility events. As evidenced by the options market, investors appear bullish on Ethereum’s long-term future, but remain concerned about the potential for a crisis in the short term.

Either way, the consolidation is one of the only recent events in the crypto market that has not been macro-driven, and it will be interesting to see if it triggers a breakout with lower correlation to the stock market, for better or worse.