JPMorgan Research Report: Why is the ETH market performing surprisingly well?

Original article by: Joshua Younger, Henry St John and Colin W Paiva, US fixed income strategists at JPMorgan Chase

Translator: Tanker

1. The Bitcoin and Ethereum markets experienced a certain degree of liquidity shock in early April. In the following days, the Bitcoin and Ethereum derivatives markets began to deleverage...

2. However, the depth of the Ethereum spot market seems to be recovering faster, and the liquidity conditions of some exchanges are even better than at the beginning of the month.

3. High-frequency cash/futures basis prices show that the Ethereum market has not been greatly affected, although the net liquidation amount is almost the same; in addition, through the open interest data, it is found that Ethereum futures trading is more likely to find market demand.

4. The transaction volume on the Ethereum blockchain is currently increasing. The significantly higher portion of the ETH token transaction volume can be considered to be highly liquid, which further weakens the impact of futures liquidation on ETH.

5. In other words, compared with Bitcoin, Ethereum's valuation is less dependent on leverage demand. With further breakthroughs in blockchain technology, Ethereum should have greater room for development.

Why is Ethereum's market performance so outstanding?

An interesting phenomenon has emerged in the cryptocurrency market in recent days, with Ethereum (ETH) outperforming other cryptocurrencies. Of course, the current price level of the ETH/BTC trading pair is still below the peak in 2017/2018, which is about 30% of the "peak price" (as shown in Figure 1).

In fact, there are fundamental differences in the narratives of the two cryptocurrencies, Ethereum and Bitcoin - Bitcoin is more like a crypto commodity that competes with gold and is a store of value; while Ethereum is the backbone of the crypto-native economy and is seen more as a medium of exchange.

In theory, in a sense, Ethereum has greater potential value and should outperform Bitcoin in the long run. However, even with the explosive growth of the DeFi market last year, Ethereum prices still seem to have not risen much, while Bitcoin still dominates the cryptocurrency market. If this trend does not change, the total value locked in DeFi contracts may slow down in recent months.

Chart 1: Ethereum has outperformed in recent days, with its relative market value to Bitcoin reaching levels not seen since the 2017/2018 market peak. (Ratio of Bitcoin to Ethereum market value, %)

Chart 2: Ethereum and Bitcoin spot markets have experienced relatively significant liquidity shocks over the past few days and have now recovered.

To put it more directly, at least a week ago, the microstructure of the Bitcoin and Ethereum markets was more or less affected by liquidity shocks.

For example, in the Bitcoin and Ethereum spot markets, market depth has declined relative to the average levels of several weeks ago, both in terms of total volume and across every major spot cryptocurrency exchange (see Chart 2).

According to the latest analysis, the liquidity shock in the Ethereum and Bitcoin spot markets mainly originated from the derivatives market and led to large-scale liquidations (see Joshua Younger’s detailed analysis on April 21, 2021 for details).

Arguably, Bitcoin appears to be more exposed to futures trading, with Bitcoin net long liquidations totaling 23% of ex-ante open interest a week ago, closely followed by Ethereum at 17%. Against this backdrop, the dramatic recovery in Ethereum market depth is all the more noteworthy (on some cryptocurrency exchanges, the recent liquidity shock has been much larger than previous ones).

But at the same time, this does raise another question: after suffering a certain "comparable" initial liquidity shock, why can ETH's liquidity recover more quickly than Bitcoin?

Again, we believe the source of this divergence may be derived from the derivatives market, and there is reason to believe that the fundamental balance of liquidity for Ethereum and Bitcoin is the same: hedge funds and other speculative investors lend to small institutional and retail participants through cash/futures basis positions (see Joshua Younger’s analysis in “Why is the Bitcoin futures curve so steep?” on April 9, 2021). Although with some “important caveats” attached, you will find that if you analyze CME futures positions by investor type, you will find that the analysis is consistent with the conclusion that Ethereum liquidity can recover more quickly, because leveraged funds are mainly short, while “unreported investors” - in this case, usually retail and small institutional investors - choose to be long (as shown in Figure 3).

Chart 3: According to data from the U.S. Commodity Futures Trading Commission (CFTC), the liquidity balance in the emerging onshore ETH futures market is similar to the net position of Ethereum and Bitcoin futures listed on CME (data time as of April 20, 2021, percentage of open interest, %)

Chart 4: Ethereum cash/futures fundamentals have performed better in recent days, with smaller price differences between exchanges, which suggests better ex-ante positioning, longer leverage base, and better liquidity recovery for ETH.

However, high-frequency basis pricing reveals significant differences in the market performance of the two cryptocurrencies, Bitcoin and Ethereum, and highlights some interesting underlying differences.

At the height of the stress, both cash/futures prices for the two major cryptocurrencies fell sharply, but this decline obviously had a much smaller impact on ETH (see Figure 4). In addition, the price difference between similar contracts across major cryptocurrency exchanges has also decreased, and has remained somewhat similar for most of the past week, which indicates that arbitrage opportunities have decreased, which in turn also indicates that the overall market performance of Ethereum has been better after the initial market price shock (and the Ethereum network hash rate has also recovered better).

So how do we understand the impact of derivatives markets on Bitcoin and Ethereum spot prices? All data points to Ethereum spot price recovery being better and more resilient than Bitcoin. The overall size of each futures market and the relative change in net liquidations are consistent: for Bitcoin, open interest is down 26% and net liquidations are down 23% compared to ex-ante levels; for Ethereum, open interest is down less than 4% and net liquidations are down 17% compared to ex-ante levels. In addition, Ethereum futures open interest on some cryptocurrency exchanges (e.g., FTX, CME, etc.) is already higher than it was before the liquidity shock earlier this month, but Bitcoin futures open interest is still falling across the board. This suggests that Ethereum futures markets are better able to find liquidation demand, thereby mitigating the impact on spot prices and recovering liquidity more quickly.

On the other hand, the “foundations” of the two public chains Ethereum and Bitcoin are also different, and therefore the liquidation mechanisms are different. Compared with Bitcoin, the Ethereum network focuses more on “transactions” (as shown in Figure 5), because Ethereum supports DeFi and other types of transactions, and the number of these transaction activities is also increasing. As a result, the liquidity of ETH tokens is higher than that of BTC (BTC liquidity ratio is about 4% in the past month, while ETH liquidity ratio is about 11%). In this case, Ethereum is less affected by the reduction of futures open interest, and its performance is even better than those crypto tokens that are frequently circulated (as shown in Figure 6). In a market with significantly higher spot trading volume, it is possible that the fundamental basis of long exposure is less dependent on leverage in the form of futures and swaps. In a market with significantly higher spot trading volume, ETH long exposure seems to be less dependent on futures and swap leverage trading.

Chart 5: The growth of DeFi has significantly increased the level of transaction activity on the Ethereum network (average daily transaction volume for Ethereum and Bitcoin)

Chart 6: As a part of highly liquid tokens, ETH futures have relatively small liquidations. Changes in open interest in BTC and ETH futures from April 17 to April 26, 2021

In a way, the topic we are discussing today may seem irrelevant to the relative valuations of the two largest cryptocurrencies. What has happened in the past week or so may soon be forgotten, especially with the current rise in cryptocurrency prices.

However, as always, the microstructure of the cryptocurrency market is instructive and can help us better understand and balance medium-term risks.

As for the relationship between ETH and BTC, at least now there is evidence that ETH liquidity is more resilient, less dependent on the transfer risk and "storage" risk of the derivatives market, and better able to respond to changes in market demand. As DeFi and other components of the Ethereum ecosystem continue to grow, Ethereum should have more room for development relative to Bitcoin.