What opportunities in the derivatives market and changes in supply and demand dynamics will Ethereum’s incorporation bring?

With all eyes on the merger, several issues loom large.
– How to evaluate hard forked tokens?
– How is the market positioned?
– How will the new supply/demand dynamics affect

Short-term and long-term pricing?

Our answers to these questions are based on a technical understanding of market structure and a fundamental view of supply and demand.

A hard fork token is unlikely to retain value in the long term, but may have speculative value in the short term.

While the merger has been generally accepted and understood by the entire cryptocurrency ecosystem, from developers to long-term ETH holders, there is a last-ditch effort by the ETH mining community to derail it. The charge was led by well-known miner Guo Hongcai. Guo Hongcai and Ethereum miners proposed a hard fork of the Ethereum main chain, which means continuing an independent copy of the existing ETH network and maintaining it through the existing Proof of Work (PoW) consensus mechanism.

After the merger, if you own ETH, you will transition to Proof of Work (PoS) ETH, which will be a new network, but will also receive a Proof of Work version of ETH (ETH PoW), as well as forked versions of ERC-20 tokens.

While ETH PoW is unlikely to threaten PoS ETH, will it still be valuable?

It is unlikely that forked ERC-20 tokens will be supported by the main protocol, which would mean that the ETH PoW platform is unlikely to have much utility and no underlying value to the L1 standard.

Still, this desperate attempt by miners is not surprising, as the switch to PoS puts miners out of business. Many of them own millions of hardware and make a living from operating it. When the merger is complete, this hardware will become obsolete.

Will ETH PoW gain long-term traction?

The merger was non-contentious, with no serious pushback from the community other than Ethereum miners, unlike what happened during the Bitcoin Cash (BCH) hard fork.

With the market so intensely focused on the Ethereum merger, it is possible that ETH PoW could see a brief moment of success, leading to a short-term appreciation in the token. However, while there is a possibility of a short-term rally in the forked token, we do not foresee any substantial interest in the forked token.

Special statement: Our article is not intended as investment advice. Please think independently. As the saying goes: Be cautious when investing and don’t trust anyone.

Without a concrete long-term use case, any initial momentum will fade away. A key opportunity could be arbitrage taking advantage of the different approaches taken by various exchanges to forks and ETH PoW tokens.

Appendix: What is a merger?
The merger is Ethereum’s long-awaited transition from Proof of Work (PoW) to Proof of Stake (PoS). It will take place in mid- to late September of this year. The move to PoS is intended to lay the foundation for improved scalability and security.
The merge has been on Ethereum’s roadmap since its inception, but now we are finally entering the final stages. All three testnets – Ropsten, Sepolia, and Goerli – have now undergone a successful upgrade.
The only event remaining before the merge is the Bellatrix update. This will prepare for the merge to the mainnet. This will happen on September 6th, which will set the total difficulty for the end. Once Bellatrix is ​​executed, the main focus will be around ETH’s hashpower.

How is the market positioning the merger?

The market suggests that a successful merger in September is the most likely outcome. Market participants will only receive ETH PoW if they hold spot ETH, but not if they hold ETH futures.

Therefore, we can infer the market estimated value of ETH PoW on a spot-futures basis. The market currently implies a price of ~$30 for ETH PoW, which is equivalent to ~1.5% of ETH's market cap. This is slightly lower than ETC, which is ~2.5% of ETH's market cap. However, we do see a lot of variation in pricing across different exchanges.

Rather than taking on ETH price risk directly, ETH holders have been positioning for the ETH PoW fork through neutral strategies in the futures market.

The typical trade is to buy spot ETH and then sell futures against it. This allows ETH holders to receive ETH PoW without the risk of price decline. Due to the uncertainty of the merger date, ETH holders have been selling September and December futures contracts. At first, selling December futures seemed like a safer bet because sellers of December contracts can still benefit from a successful merger in September. If there are any hiccups, the price action of the September basis may become chaotic, while the December basis will be more likely to retain value. As of August 17, 2022, the September spot futures basis is ~$23, while the December basis is ~$30.

However, as a September merger date becomes more likely, the futures discount has become concentrated in September.

The impact of spot-futures basic transactions on the market

The extent of the impact on the market is best illustrated by the recent change in the shape of the futures curve. Due to funding costs, the ETH calendar spread usually trades in equal distances (positively sloping). However, due to the large amount of selling that has occurred in the less liquid long-term contracts, the curve has been distorted into a divergent state.

Red: December position. Blueprint: September position. Green: December-September position

How long the curve will remain in this shape remains to be determined. Based on the current spot ETH price and the increasing likelihood of a September consolidation, this may only last in the short term.

Overall, widespread approval of the transition to PoS suggests that underlying transactions will be liquidated quickly after the merger, with ETH holders receiving their ETH PoW. This market anomaly should not last long after the merger. Especially if the merger proves to be successful and spurs a broader rally.

ETH volatility dominates BTC volatility, while BTC lacks a catalyst. Consolidation serves as a catalyst, while BTC lacks a clear macro direction. Since the Q2 2022 sell-off, market participants have been reluctant to redeploy capital into risk assets until there is more certainty about the interest rate outlook. Instead, we are seeing many market participants use options strategies to express their views on consolidation to limit their downside risk. As a result, for the first time, we are seeing open interest in ETH volatility surpass open interest in BTC volatility.

Special statement: Our article is not intended as investment advice. Please think independently. As the saying goes: Be cautious when investing and don’t trust anyone.

Nominal value of vol:

Most of the structure we are seeing in ETH options is upside calls. This flow has driven the "BTC vol to ETH volatility" ratio to the lower end of its historical trading range of 60-95%. Currently, ATM ETH volatility for Sep 30 is just over 100%, and the BTC/ETH volatility ratio is just under 70%. This means that ETH has a 1.5x excess return compared to BTC. Considering this is a high-variability event, we believe this is a fair price for ETH volatility.

Additionally, the previously discussed spot-to-futures trade could lead to further short-term volatility. However, the market expects volatility to decrease post-merger. While maturities are getting steeper, volatility is downward sloping post-September option expiration because of the merger.

From the open interest heat map below, most of the bullish strategies are shown at the $3k level and butterflies. Taking the $2500-3000-3500 Dec 30 expiration butterflies as an example, this means that market participants are targeting $3000 ETH to maximize profits. It is important to realize that as ETH rebounds, option market makers will begin to derive when the price of ETH approaches the first strike price of around $2500. Therefore, if the spot approaches this level, there may be a larger move higher in both ETH Vol and spot ETH as market makers hedge their risk.

The fork also creates distortions in the DeFi borrowing market. Market participants borrow ETH to obtain ETH PoW. As long as the interest rate paid is lower than the value of ETH PoW, it is profitable to borrow more, which further drives up borrowing rates. If the interest rate is not high enough, it will also cause the borrowing pool to be 100% utilized. This makes it impossible for lenders to exit. The removal of miner pressure may be bullish. There are two short-term factors to consider.

Supply and demand

ETH Price Since the crash, ETH has been trading in a clear range of $1000-$2000. This price has held up well despite ~$40 million of miner selling per day, which means there is also ~$40 million of buying demand per day. Assuming the ETH PoW fork does not lead to a strong new market, we can safely assume that this $40 million of daily selling will disappear once the PoS chain is established.
As demand persists and supply decreases due to consolidation, we expect upward price pressure to resume. This should ultimately look very similar to what happened after the miner reward halving, which is typically followed by bullish price action.

locking

The locked ETH will remain locked until the next Ethereum Improvement Proposal (EIP-4788) releases them in the future. While the implementation date is currently unclear, we do know that 13.2 million ETH, or approximately $21 billion in ETH, will be eligible for withdrawal. Of course, it is unlikely that all currently staked ETH will become uncollateralized. Furthermore, even if all staked ETH is uncollateralized, there will be a queue that takes an average of 6 months to process. This potential unlocking could weigh on the market until there is more certainty around the actual amount of ETH unlocked and sold. The unlocking is essentially a "fact of sale" event, not an actual merger. If the merger is successful, it should be the price of ETH that rises again as miners' supply decreases.

Long-term view on ETH after the merger

While the conflicting factors mentioned above may create some uncertainty in the short term, we are confident that the merger will ultimately lead to higher prices in the long term. We have seen increased interest in various call option strategies and following recent large cash positions.

Overall, we expect effective supply to fall by ~95% while staking demand increases post-merger. Our positive long-term view is based on the following factors.

– On the supply side

We see total inflation falling by ~90%, with 15% gas fees paid to miners/savers remaining stable. However, effective supply should fall by more than 95%, as we believe miners sell ~80-90% of ETH, while we very roughly estimate minters will only sell ~20% due to the massive reduction in operating costs.

- On the demand side

There are three components.

1. Gas : Currently about 110k ETH per month, of which about 85% is burned. We assume this number remains stable after the merger, although we think this estimate is likely conservative.

2. Staking Demand : Currently ETH staking is negligible. The likely reason is that stakers are waiting to take action after the merge, given the potential technical risks and uncertain timing. Currently, only about 11% of the total supply is staked, which is significantly lower than the 50-80% average for major PoS L1s. Assuming a conservative total stake ratio of 60%, this means an additional 60 million ETH is staked out of the current supply of 120 million tokens at a current supply of about 60%. A reasonable timeframe to reach this target is about 16 to 20 months. While much of this demand will ultimately come from existing ETH holders, we expect about 10% net new users with an expected yield of 5%+.

3. Speculative demand : While this is difficult to estimate, in previous bull markets we typically saw 2M ETH per month being moved from long-term investments to investments. Therefore, even without any pick-up in speculative demand, we think the supply-demand balance will move from the current slight oversupply to a moderate oversupply. This would mean moving from ~260K ETH per month that needs to be absorbed by speculative demand to ~400K ETH per month of excess demand. Given current cash levels, this estimate is likely conservative. There is considerable upside if combined.
   To put this into context, approximately 75% of the current supply has not changed hands in three months. In other words, these tokens are in the hands of quasi-long-term holders. This further exacerbates any potential supply squeeze hinted at in the analysis below.

Summarize:

In the long run, this upgrade has far-reaching implications. The Ethereum network will have better economic incentives and more validators, laying the foundation for future scaling upgrades. ETH issuance has the potential to become deflationary during periods of high demand. Miners typically sell 80-90% of their rewards to cover high energy costs, and with the elimination of overhead, miners' selling pressure is expected to drop significantly. Overall. Even without a substantial pick-up in new speculative demand, we believe the market will transition from flat/oversupplied to significantly undersupplied.