Arthur Hayes: Predicting the likelihood of a successful Ethereum merger and market trends

The core theory of American financial tycoon George Soros, the "Reflexivity Theory", refers to the existence of a feedback loop between market participants and market prices - the market participants' views on a particular market situation will influence and shape the development of that situation. The expectations of market participants will affect market facts (fundamentals), and market facts in turn will shape the expectations of participants. In other words, participants, consciously or unconsciously, often play an important role in promoting the future they predict. Their biases will strengthen the trend of prices rising or falling, because the future will become a self-fulfilling prophecy.

I will apply this theory to discuss the Ethereum merger. The conclusion is: the merger itself is not affected by the price of Ethereum, and its success or failure depends entirely on the skills of the Ethereum core developers.

The merger will bring two changes

1. It will eliminate PoW ETH emissions per block (i.e. ETH paid to miners in exchange for the computing power they provide to maintain the network). Currently, these emissions total about 13,000 ETH per day. After the merger, the 13,000 ETH per day emission from miners will be replaced with a smaller 1,000 to 2,000 ETH per day emission from network validators (i.e. those who use ETH in exchange for more ETH by helping to determine which ETH transactions are valid and which are invalid). These emissions will occur at the same rate, regardless of the price of ETH and usage of the Ethereum network.

2. Each block burns a certain amount of gas fees (which means that the ETH used to pay these fees is permanently removed from circulation). This variable depends on the usage of the network. The usage of the network is a reflexive variable, which I will explain in more detail later.

Total ETH inflation = block emissions - gas burn fees

I treat block emission as a constant for current local conditions. Gas fees depend on network usage.

• Inflation = Block Emissions > Gas Fees

• Deflation = Block Emissions < Gas Fees

Those who believe that ETH will become a deflationary currency must also believe that network usage (and therefore the fees paid by users for ETH consumed) will be high enough to offset the ETH emitted per block as a validator reward. However, to evaluate whether they might be correct, we must first ask — what determines the usage of a crypto network like Ethereum?

When choosing an L1 smart contract network chain, users have many choices. Other L1 chains include Solana , Cardano, Near, etc. The following are the factors that I think affect users' choice of L1 chain:

1. Market participants’ views on the market situation;

2. Applications: Which network has the most robust Dapps? Which of these applications are leading? Which of these applications has the most transaction liquidity?

Market participants’ predictions of the situation

The media hype ratio has a reflexive relationship with the price of ETH. The above graph shows Ethereum Google search trends and Ethereum price. You can see that they are closely correlated. If I run a correlation between the two data series, r = 0.77. Conceptually, this makes sense. People's interest in the Ethereum network rises and falls with the price of its native token - as the price rises, more people hear about Ethereum and want to buy and use the network, further driving the price up.

app

The quality of applications on a network depends on the quality and quantity of engineers working on the network. As a developer, you build things for people to use. If no one is using the network, you are unlikely to develop on it. Obviously, developers want to write code in a language they are familiar with, but this preference is secondary to the number of users who can interact on a given decentralized network.

The number of developers is directly related to the number of users their creations can serve. As we established above, the number of users of a given network is directly related to the price of the native token. Because the number of users and price share a reflexive relationship, the number of developers and price must also share a reflexive relationship. As the price increases, more people hear about Ethereum, more people use the network, and more developers are attracted to develop applications on the network, which attracts a large and growing user base. The better the applications, the more users join the network.

Two possibilities for the future of crypto

• The degree of deflation in ETH depends on the gas fees burned.

• The amount of gas fees depends on how much the network is used.

• The usage of the network depends on the number of users and the quality of the applications.

• The number of users and the quality of applications have a reflexive relationship with the price of ETH.

Therefore, from the transitivity, we can see that there is a reflexive relationship between the magnitude of deflation and the price of ETH. Taking this into account, there are two possibilities for the future of the crypto world.

If a merger occurs:

If the merger is successful, there is a positive reflexive relationship between price and the amount of money deflation. So traders will buy ETH today, knowing that the higher the price, the more the network will be used, the more deflationary it will become, driving the price higher, causing the network to be used more, and so on. This is a virtuous cycle for the bull market. When everyone has an Ethereum wallet address, there will be a ceiling.

If the merge does not occur:

If the merger is unsuccessful, there will be a negative reflexive relationship between price and the amount of deflation. Or, to put it another way, there will be a positive reflexive relationship between price and monetary inflation. Therefore, in this case, I think traders should either go short or not hold ETH.

There is a bottom line to this relationship as the network is the longest operating decentralized network. ETH has gained a huge market cap without a merger. The hottest Dapps are built using Ethereum and Ethereum also has the most developers of any L1 chain. As I mentioned in my previous article, I believe that the price of ETH will not go lower than the $800-1000 it experienced during the TerraUSD or Three Arrows Capital crypto credit crash.

Market Opinion

We now need to determine the market's perception of the merger's success or failure.

In my opinion, this can be best answered from the chart below, which shows the ETH/ BTC ratio. The higher the ratio, the more ETH outperforms Bitcoin. Since Bitcoin is the reserve asset of the crypto capital market, in my opinion, if ETH outperforms Bitcoin at this stage, it means that the market believes that the probability of a successful merger is increasing.

Since the crypto credit crisis, ETH has outperformed BTC by about 50%. Therefore, I think it is reasonable to assume that the market is becoming more and more confident that a successful merger is imminent. The current expected merger date proposed by Ethereum core developers is September 15, 2022. But this is just the spot market's view. What about the derivatives traders' view?

The above chart illustrates the term structure of ETH futures. The futures term structure plots the current price of futures contracts against their expiration time. It allows us to predict supply and demand conditions at different maturities by calculating the premium or discount of futures contracts relative to the underlying spot price.

• Backwardation = Futures Price < Current Spot Price; Discounted Futures Trading

• Futures price > current spot price; trading in premium

Considering that the entire curve through June 2023 is trading in backwardation, this means that the futures market predicts that the price of ETH will be lower than the current spot price by the expiration date. On a profit margin, selling pressure is greater than buying pressure.

Here is a chart of ETH futures open interest. Open interest is the total number of open futures contracts held by market participants at a given point in time. As you can see, it is rising from the lows seen during the crypto credit crash in mid-June. The increase in open interest coincides with the curve being in backwardation. To me, this suggests increasing selling pressure. Conversely, if the curve was in contango (futures price > current spot price) and open interest was increasing, it would indicate significant and rising buying pressure at the margin.

Two potential reasons for the current selling pressure

1. You are long ETH but unsure if or when the merger will happen, so you fully or partially hedge your ETH exposure by selling futures contracts at a premium to the current spot price.

2. You want the merger to happen and want to be able to pick up free public chain split tokens, which will be minted and distributed to all ETH holders when some of ETH's related tokens resist the merger and create a fork to maintain ETH's PoW chain. So, you are long Ethereum, but you also want to hedge your Ethereum risk by selling futures contracts. If you sell the futures contract at a discount to the value of the chain split tokens you receive, then you can make a profit.

But remember I just showed ETH outperforming BTC by 50%. The selling by market makers in the spot market was not matched by the long long flows. This means that the market’s confidence in a successful consolidation is being underestimated and masked by the short hedging liquidity of market makers.

If the market believes that the chances of a merger happening are increasing every day, what happens to those who hedged via futures contracts if the merger goes through?

1. If the merger goes through, those holding ETH spot will buy back their hedges so they can benefit from the positive reflexivity I described above.

2. If the merger is successful and the chain split tokens are distributed, they will be sold at any value and those who hedged their positions will be immediately closed. Now, they may decide to sell spot ETH and completely close their positions, but I bet these traders will be in the minority. The possibility that ETH can benefit from positive reflexivity will be discovered.

I think a successful merger will create some level of buying pressure, reversing market makers' futures positions in the process. They will go from long/short futures to liquidating or short/long futures. The spot they were short will have to cover (which means buying spot), and if they were net short futures, they will now have to enter the market to buy additional spot. The liquidation of derivative flows that led to backwardation before the merger will lead to contango after the merger.

Trading Decisions

For those who believe the merger will go through as planned, the question becomes: How do you express your bullish view?

Spot/ETH

The most straightforward trade is to buy ETH with fiat, or to add ETH to your crypto portfolio.

Lido Finance

Lido Finance is the largest Ethereum Beacon Chain validator. Lido allows players to stake ETH to get validator rewards. In return, Lido will receive 10% of the ETH rewards. Lido has a DAO that issues tokens - LDO.

This is an attractive option if you want to take on more merger risk. It is riskier than owning spot ETH because Lido’s value proposition is entirely dependent on the success of the merger — whereas with spot ETH, it may still be successful because it has other value propositions (i.e. powering the second largest public chain by market cap).

As the beta of the merger has been higher, LDO has risen more than 6 times since the mid-June crypto credit crash.

Long ETH Futures

For those who want to gain more benefits by increasing leverage trading, going long on ETH futures is a good option. Since the basis is negative, those who hold long futures positions are rewarded for holding ETH exposure.

Basis = Futures - Spot

From a term structure perspective, the December 2023 futures contract is the cheapest. If the merger is successful, due to the remaining time value, the September 2023 futures contract will have 1 to 2 weeks of time value after the merger, and you will not get the same basis effect as long December futures.

Long ETH Call Option

For those who like leverage but don’t want to worry about getting liquidated like futures contracts, buying call options is a good strategy. Currently, the implied volatility of September and December futures is lower than the realized volatility. This is expected because hedgers use not only futures contracts but also options.

Interestingly, when I entered the market to buy the Dec 2022 $3000 ETH call option, I was able to trade with quotes much larger than what was on the screen. I was told this is because traders are all heavily long call options and hedgers are hedging their long ETH positions with long covers. Traders are more than happy to reduce their long call exposure as it frees up margin and they are showing very tight prices in terms of quotes.

Similar to the futures term structure, December options have lower implied volatility than September options. Another reason I prefer the December 12 call is that I don’t need to be as precise on the timing of the merge. While the developers told us the merge is September 15, the technical delivery date is well known. I don’t want to worry about a few weeks of holiday time on the merge completion date.

Long December Futures vs. Short September Futures

This is a curvy approach. You need to watch your margin very carefully. While you have no exposure to the ETH price, you will be showing unrealized losses on one hand and unrealized profits on the other. If the exchange in question does not allow you to offset these losses, then you will have to add margin for the losing portion of the trade, otherwise, you will be liquidated.

Buy when the rumor starts, or sell when the truth comes out?

Assuming you are long via some Ethereum-related tool, the question becomes – do you fully reduce your holdings or close your position before the merger occurs?

Since positive reflexivity drives the price of ETH higher before the merger, “The textbook trade: You should at least sell off before the merger. However, reality rarely lives up to expectations.

However, a structural decrease in inflation will only occur after the merger. I hope we will see something similar to the Bitcoin halvings. That is, we all know the date they will occur, but Bitcoin still rebounds after the halving.

That said, there is a chance that the price of ETH will drop slightly after the consolidation. Those who cut their positions partially or fully will initially be happy with their decision. However, as deflation sets in, prices may grind higher due to the reflexive relationship between high and rising ETH prices and network usage. At that point, you have to decide when to get back into your position. This is often a very challenging trading situation. You believe in the long-term trend but want to trade around your position. Now, you have to pay a higher price to re-establish your position. But you are always waiting for a drop when you know it is time to buy back in. But that drop, or at least a drop of the magnitude you were expecting, never happens and you either never re-establish the same position or you miss out on a large portion of your gains.

With this thought experiment in mind, and my belief in the reflexivity of this situation, I will not reduce my position around the consolidation. But I will add to my position during the market sell-off, because I believe the best price is yet to come.

How to sell

To think further, we must also consider the best strategy to shorten the time it takes for a merger to occur. Given the current market sentiment and price action, those who short ETH before the merger are fighting a positive reflexive trade. This is a very dangerous situation. When you short something, your maximum gain is 100% unaffected because the price can only go to zero (while the maximum loss on the upside is unlimited). Therefore, timing is very important.

The best time to short the trade is before a consolidation occurs. This will be when expectations are highest and you have a short time between entering the trade and when the consolidation does or does not occur. If the consolidation fails, the sell-off will be swift given the high expectations and objective reality of the market. This will allow you to exit the trade quickly with profits in hand.

I recommend using put options. Referring to the futures curve above, the discount on March 2023 futures is the smallest. This means that as a short, you pay the least. This also means that the March 2023 put option will be the most attractive. If I were short, I would buy a 1,000 ETH put option on September 14, 2023. You know your maximum loss in advance, which is the premium of the put option. This will allow you to eliminate unlimited losses if the merger is successful. Your downside goal is a quick move below $1,000.

Summarize

This article helps me really think about my trades and ultimately increase my confidence in my portfolio positioning. If I can't logically explain the thinking behind my portfolio, then I need to re-examine my trading decisions. In the process of writing past articles, I have made significant changes to my portfolio and lost confidence in previously held beliefs because I couldn't defend them well enough in written form.

I tried to apply the reflexivity theory of financial tycoon Soros to the ETH merger, which increased my confidence. I questioned what I should do to lead the merger, and after putting these ideas on paper, I knew that bottom fishing was always the theme.

Note: Any views expressed in this article are the author’s personal views and should not be used as a basis for making investment decisions, nor are they investment trading advice.