Ethereum: The Merge Is Coming
- By Bilal Hafeez and Dalvir Mandara
- 10 min read
Summary
Trading View (next 2-4 weeks): We like to be neutral ethereum.
Investment View (next 1-3 years): We like to hold ethereum.
Macro Signals
- We expect the Fed to hike more than the market is currently pricing.
- The probability of a recession stays near 70% after Friday’s employment report.
- The macro backdrop is bearish for ethereum.
On-Chain/Flow Signals
- We have three bullish, two bearish, and two neutral signals this week.
Overall View
- With the macro backdrop bearish, our on-chain/flow metrics slightly bullish, and sentiment around the upcoming merge bullish, our overall signal is neutral ethereum (Chart 1).
The Merge Is Coming
The ethereum merge is quickly approaching. The latest expectation is for it to commence around 15 September. Given the prospect of yield on staked ETH and a huge drop in energy consumption, the transition to proof-of-stake positions itself well for a bullish narrative.
The merge has already been the source of an impressive rally since ethereum developers first hinted at a tentative timeline back on 14 July (at the time, the merge was expected to occur around 19 September). Since then, ethereum has increased a whopping 56% (Chart 2).
It is not just prices that have been rallying on the merge excitement. The futures trading volume for ethereum has been increasing since July, while that for bitcoin has been trending down (Chart 2). The 30-day moving average of the futures trading volume for ethereum has now topped that for bitcoin. This points to more investor interest in ethereum. Moreover, ethereum has been outperforming bitcoin lately. The cross (ETH/BTC) is increasing and currently sits at around 0.08, up from lows of 0.05 in July.
Whales Accumulate
Large holders of ethereum have been continuing to accumulate holdings. The supply held by addresses with at least 100,000 coins is reaching new year highs (Chart 4). That the largest holders of ethereum are increasing their exposure in the run-up to the merge is a bullish sign.
Investors Are Betting on Higher Yields on Staked ETH
After the merge, validators will earn interest on their staked ETH as a reward for participating in the network. This potential to earn a passive return (via yield) on staked ETH is one of the main reasons for considering the merge bullish, and it will likely attract more investors into the space.
One way of expressing a view on where you think the yields will go is via an interest rate swap. The most common type is a fixed for floating swap. This is where party A makes a future stream of payments based on an initially agreed fixed rate of interest to party B. In return, they receive payments based on a floating interest rate (usually this is based on an index such as LIBOR).
Party A could enter the swap as a floating rate receiver if they believe future rates will be higher than the fixed rate they agree to pay. And they would profit from the difference. This would be taking the view that rates will increase in the future. These types of instruments are commonly also used to hedge interest rate risks.
You can imagine a similar setup for traders betting on future yields for staked ETH. You would want to be a floating rate receiver if you believe that staked ETH yields will increase over time.
Voltz is a new DeFi protocol that allows the trading of leveraged interest rate swaps for crypto markets. There is a stETH pool that allows traders to take positions on future yields for Lido’s staked ETH. These swaps expire on 31 December 2022.
According to data from Dune, the proportion of traders that are variable takers (i.e., receive floating rates) in the stETH pool is 82% (Chart 5). This suggests a large majority expect rates to be higher in the near future (up to 31 December 2022) than they are today. Were this to play out, not only would those investors make money, but it would also be increasingly bullish for ethereum as higher yields on staked ETH will attract more investors to the space. There is, of course, always the risk that yields do not increase.
The Macro Backdrop Remains Bearish
The macro backdrop for crypto remains bearish on rate hikes and inflation. The probability of recession remains high at 70%, and we expect the Fed to hike more than markets are pricing in. We get August CPI data on 13 September, and the Fed meets on 20-21 September for their next policy decision. Both dates will be important for risk markets (of which crypto is increasingly a part) and broader risk sentiment in general.
On-Chain/Flow Metrics: Long-Term HODLers Dominate
We have three bullish signals this week:
- There have been large exchange outflows.
- The long-term HODLer vintage (1y+) has jumped to almost 60%.
- Ethereum’s total value locked in DeFi is increasing again.
We have two bearish signals:
- ETF outflows.
- Realised losses on-chain.
The remaining two signals are neutral:
- Hash rate is increasing, but miner revenues are still decreasing.
- Futures open interest is increasing, but perpetual funding rates are still negative.
On balance, on-chain/flow metrics are giving a slightly bullish signal for ethereum. Here are the details of each metric (with explanations in the Appendix).
Institutional Demand: Bearish Ethereum
Our preferred metric to track institutional demand is flows into ethereum ETFs. Outflows have outweighed inflows in both quantity and magnitude recently (Chart 6). This is bearish ethereum.
Demand for Liquidity and Exchange Activity: Bullish Ethereum
On exchange flows:
- Short term, a bias exists for outflows from exchanges persists. Net 780,000 coins left exchanges over the past two weeks (Chart 7). Two days stand out: 28 and 29 August saw net outflows of 380,000 and 476,000 coins, respectively. This is bullish ethereum.
- Longer term, the 30-day change in the exchange balance reveals fluctuations in the supply held on exchanges month on month. This metric remains in negative territory (Chart 8). This is bullish ethereum.
Futures Activity: Neutral Ethereum
Futures open interest is up 9% over the past two weeks – it is currently around $7.2bn (Chart 9). Around $5.3bn (74%) of this comes from perpetual futures contracts.
Perpetual funding rates reveal the directional bias of investors. On average, they have resumed an uptrend but remain well within negative territory (Chart 10).
Overall, futures open interest is increasing (bullish), but funding rates are negative (bearish). Together, we view this is a neutral for ethereum.
HODLers: Bullish Ethereum
The 30-day moving average of the coin days destroyed (CDD) metric is up 10% over the past two weeks (Chart 11). This suggests increasing distribution of older coins.
Splitting HODLers into those who have held for under one year and those for one year or more shows the 1y+ vintage jumped to 58% on 26 August (Chart 12). It was 47% the day before (25 August). This suggests a significant proportion of the coin supply (around 10%) was acquired in August 2021, before the November 2021 all-time highs, and has held since. Despite the extreme volatility and macro headwinds crypto markets have been subjected to since setting those all-time highs, there still seems to be a sizable investor base with a strong conviction to hold.
We view these HODLer metrics as bullish for ethereum because a significant portion of the supply has held their coins throughout the challenging macro landscape that risk assets have faced this year.
Investor Profit and Loss: Bearish Ethereum
On profitability of the coin supply:
- The percentage of circulating supply in profit (PSIP) is 55% (Chart 13). This is up just 1pp over the past two weeks.
- Net unrealised profit/loss (NUPL) is 0.06 (6% of market cap) (Chart 14). This means that the overall ethereum supply has moved back into an unrealised profit as market cap exceeds realised cap. We would look for a sustained period above zero to signify further upside for ethereum.
- Spent output profit ratio (SOPR, price sold/price paid) has been below one (net losses) for 12 of the last 14 days (Chart 15).
Together, PSIP has been relatively flat, and NUPL is only just above 0 (net unrealised profits). We would look for a sustained rise in both for a bullish sign. Realised losses on chain have returned. Overall, we view this as bearish ethereum.
Mining Activity: Neutral Ethereum
The hash rate is up 4% over the past two weeks (Chart 16). However, miner revenues are down 4% over the same period (Chart 17). Together, we view this as neutral ethereum.
DeFi: Bullish Ethereum
The total value locked (TVL) in DeFi across all protocols is currently around $59bn – up 2% over the past seven days. All chains in the top five by TVL except for Avalanche are up in terms of their TVL on the week (Charts 18 and 19). However, ethereum and solana are up the most at 4% each. This is bullish ethereum.
Bottom Line
We have introduced a framework for understanding the flow and microstructure dynamics of ethereum markets. The seven key metrics are:
- Institutional demand: ETF outflows. Bearish ethereum.
- Liquidity demand: bias for exchange outflows. Bullish ethereum.
- Futures activity: futures open interest rising but perpetual funding rates still negative. Neutral ethereum.
- HODLer behaviour: longer-term HODLer vintage jumps. Bullish ethereum.
- P&L of investors: realised losses on chain. Bearish ethereum.
- Mining activity: hash rate increasing but miner revenues decreasing. Neutral ethereum.
- DeFi activity: TVL of ethereum is up 4% over the past week. Bullish ethereum.
Appendix
Institutional Demand
Perhaps the largest institutional vehicle for ethereum is the Grayscale ETHE Trust, with over $27bn in assets. It invests solely in ETH, and so many investors, notably institutional, who cannot hold ETH directly can get exposure through investing in Grayscale. Consequently, if the trust trades at a premium to ETH prices, it may imply ‘excess’ demand from institutions, but ‘excess’ supply if it trades at a discount. Alternatively, the discount may suggest investors have found other ways to get exposure to ETH, whether through ETFs or directly holding ETH. We therefore focus on how the discount has changed in recent months to gauge investor interest. Alternatively, investors may be using other vehicles to get exposure such as ETFs or holding ETH directly. We put more weight on ETF flows than the Grayscale premium.
Liquidity Demand
Another measure of cryptocurrency bullishness is whether investors are willing to hold it in illiquid form (e.g., a private wallet) or prefer a liquid form (e.g., on an exchange). The former would suggest investors are bullish, as they are comfortable with being unable to sell easily. Conversely, holding it in liquid form would suggest investors are bearish, as they prefer being able to sell easily.
Therefore, large flows onto crypto exchanges would suggest investors want to convert their holdings to a more liquid form, implying more bearishness.
Futures Activity
We track the growing market of ethereum futures. Open interest – the sum of long and short contracts – is a good measure of investor interest.
Perpetual funding rates reveal the directional bias of investors. Exchanges set funding rates to prevent a lasting divergence in the price of the futures contract and the underlying since perpetual contracts have no expiry date so never settle in the traditional sense. Consequently, we can interpret funding rates as the cost of holding ethereum via perpetual futures. Positive funding rates imply longs pay shorts and vice versa. We use it as a proxy for trader sentiment since a positive funding rate implies traders are paying a premium to keep open long positions.
HODLers
In our introductory bitcoin flow framework, we explained ‘HODLers’ and ‘HODLing.’ HODLing refers to buy-and-hold strategies in the context of bitcoin and other cryptocurrencies. Those who HODL for extended periods are die-hard adherents.
We can categorise HODLers by the length of time they have held ETH. We define long-term or staunch HODLers as those who bought ETH five or more years ago and have held it ever since, medium-term HODLers as those who bought 6-12 months ago, and short-term HODLers as those who bought 3-6 months ago.
The coin days destroyed (CDD) metric is defined as the number of coins in a transaction multiplied by the number of days since the coins were last spent. So, increasing CDD suggests older coins are being spent (more coin days are destroyed) and vice-versa.
Profit and Loss
- The percent supply in profit (PSIP). This tracks the share of circulating ETH supply in profit. That is the percentage of circulating ETH whose current price is higher than when it was last transacted (movement).
- Net unrealized profit and loss (NUPL). This is the ratio of unrealised profits over total market capitalisation. While PSIP just focuses on whether ETH coins are in profit or not, the NUPL focuses on the size of profits. So, we could have a situation where the PSIP is low – that is, a low share of supply is in profit – but the NUPL could be high if the size of those profits is large.
- Spent output profit ratio (SOPR). While PSIP and NUPL focus on unrealised profits or mark-to-market, this measure focuses on realised profits. SOPR is the realised value of a transaction divided by the value at initiation (or creation) – more simply, price sold divided by price paid. If SOPR is above one, investors in aggregate have realised profits, while below one means they have realised losses. In broad uptrends, SOPR spends a significant amount of time above one, whereas the opposite is true for broad downtrends.
When SOPR is rising, sellers are increasingly realising profits. The opposite is true when it is falling. A price rally with a flatter SOPR trend indicates investors are not yet realising their profits with the rally. The reluctance of investors to sell and realise a profit may be because they believe the price will increase further, which would be bullish. At the same time, more profit taking could precede a correction. Typically, buying as SOPR moves around one during bullish periods has proven to be a profitable strategy.
Mining Activity
Computing power is central to the crypto market. Miners use advanced computing hardware to solve complex problems that confirm ETH (and other coins) transactions on the public ledger or blockchain. The miners are rewarded with new coins for their efforts. A measure of the complexity of the problems and so the computing performance required to solve them is the hash rate. The higher this rate, the more computing performance is needed to maintain the blockchain. The rate can fluctuate depending on demand for crypto.
DeFi
We track the total value locked (TVL) in decentralized finance (DeFi) – the sum of all assets deposited in DeFi protocols, many of which use ethereum as the underlying protocol. The more DeFi products are created, the more ethereum gets locked into the DeFi system and removed from the broader market. This reduction in supply should lead to higher ethereum prices.