Whales Buying Ethereum Ahead of Merge

Summary

Trading View (next 2-4 weeks): We like to be bullish ethereum.

Investment View (next 1-3 years): We like to hold ethereum.

Macro Signals

• Fed to hike 75bps at the next policy meeting this week.
• The probability of a recession is near 70%.
• The macro backdrop is bearish for ethereum.

On-Chain/Flow Signals

• We have six bullish signals and one neutral signal this week.

Overall View

• With the macro backdrop bearish and on-chain/flow metrics very bullish, our overall signal is bullish ethereum (Chart 1).

Ethereum Rallies on Tentative Merge Timeline

Crypto markets have been rallying throughout the second half of July, with smart contract platforms like ethereum taking centre stage. Our latest Crypto Index Tracker revealed our Smart Contract Index is leading gains among other crypto sectors like DeFi and the Metaverse.

Ethereum has by far outperformed the rest this month. So far, it is up a staggering 45% in July (Chart 2). For comparison, bitcoin is up just 14%. This is ethereum’s second-highest monthly return for July since 2016. Only July 2020 beat it, when ethereum gained 50%. We still have a around a week left to see if ethereum will break the record for July gains.

Ethereum Is Outperforming Bitcoin

Bitcoin has been outperforming ethereum this year, with the ETH/BTC cross reaching yearly lows of around 0.05 in June. However, July has flipped this trend on its head, with the cross shooting up (Chart 3). But what is driving this outperformance? The answer lies in the upcoming ethereum merge (when the protocol moves from proof of work to proof of stake).

Whales Are Accumulating

Delays have plagued the ethereum merge. Yet the developers clarified a tentative timeline in a call on 14 July, and ethereum subsequently staged an impressive rally (Chart 4). The tentative date for the merge is 19 September.

Big investors accumulating ethereum has also bolstered sentiment. The total supply held by addresses with a balance of at least 100,000 coins has been increasing in line with price action ever since that developer call (Chart 5).

In a previous ethereum update, we discussed the implications of the merge. The punchline was it would be bullish for these reasons:

1. Validators can earn yield on staked ETH post merge. The prospect of a passive return on staked ETH is attractive.
2. Net issuance is projected to drop considerably post merge. If demand continues to rise, the reduction in supply should be bullish for ethereum.
3. Ethereum may become deflationary.
4. Increased scalability and security. Post merge, ethereum is expected to be able to handle around 100,000 transactions per second. Currently, it handles around 30.
5. ESG concerns are alleviated for institutional investors as ethereum replaces the energy-intensive proof-of-work consensus protocol with proof-of-stake.

On-Chain/Flow Metrics: ETF Outflows

We have six bullish signals this week:

• ETF inflows.
• Bias for exchange outflows.
• Futures open interest and perpetual funding rates increasing.
• Increased profitability of the coin supply.
• Hash rate and miner revenue are both increasing.
• Ethereum’s TVL in DeFi is increasing.

We have one neutral signal:

• Longer-term HODLer vintage is decreasing.

On balance, on-chain/flow metrics are giving a very bullish signal for ethereum. Here are the details of each metric (with explanations in the Appendix).

Institutional Demand: Bullish Ethereum

Our preferred metric to track institutional demand is flows into ethereum ETFs. Inflows have returned (Chart 6). This is bullish ethereum.

Demand for Liquidity and Exchange Activity: Bullish Ethereum

On exchange flows:

• Short term, a bias exists for outflows from exchanges. Net 2mn coins left exchanges over the past seven days (Chart 7). This is largely due to a spike in net outflows of around 2.3mn coins on 23 July alone. 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 has flipped back into negative territory after the large outflows over the past week (Chart 8). This is bullish ethereum.

Futures Activity: Bullish Ethereum

Futures open interest is trending up – it is currently around $6bn, up 30% over the past 14 days (Chart 9). Around $4.9bn (82%) of this comes from perpetual futures contracts.

Perpetual funding rates reveal the directional bias of investors. On average, they have resumed an uptrend (Chart 10).

Overall, futures open interest is increasing sharply, and funding rates are positive: this is bullish ethereum.

HODLers: Neutral Ethereum

The 30-day moving average of the coin days destroyed (CDD) has been elevated over the past week (Chart 11). This suggests more distribution of older coins.

Splitting HODLers into those who have held for under one year and those for one year or more confirms this as the 1y+ vintage is decreasing materially (Chart 12). This vintage now dominates 54% of the coin supply compared with 60% at the start of June and the year highs of 63% in March.

That older hands are selling could be viewed as bearish. But the <1y vintage correlates with price action more than the 1y+ vintage, and since we are seeing an uptick in the <1y vintage, this could be viewed as bullish. On balance, we view these HODLer metrics as neutral for ethereum.

Investor Profit and Loss: Bullish Ethereum

On profitability of the coin supply:

• The percentage of circulating supply in profit (PSIP) is 61% (Chart 13). This is up 6pp over the past seven days and 11pp from our last ethereum update.

• Net unrealised profit/loss (NUPL) is 0.07 (7% 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.

• Realised profits return on chain. Spent output profit ratio (SOPR) (price sold divided by price paid) has been above one (net profits) for six of the last seven days (Chart 15).

Overall, we have seen a jump in the profitability of the ethereum supply, which is bullish.

Mining Activity: Bullish Ethereum

The hash rate has been in a broad downtrend since May 2022 (Chart 16). However, it is starting to recover and is up 3% over the past week. Miner revenues have also benefitted from the ethereum rally – they are up 10% over the past week (Chart 17).

DeFi: Bullish Ethereum

Our latest Crypto Index Tracker revealed our Smart Contract Index leads gains as crypto markets rallied last week. The total value locked (TVL) in DeFi across all protocols is currently around $85bn – up 6% over the past seven days. All chains in the top five by TVL are up in terms of their TVL on the week (Charts 18 and 19). However, ethereum TVL is up the most at 8%. 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:

1. Institutional demand: ETF inflows return. Bullish ethereum.
2. Liquidity demand: bias for exchange outflows. Bullish ethereum.
3. Futures activity: futures open interest and perpetual funding rates are rising. Bullish ethereum.
4. HODLer behaviour: longer-term HODLer vintage decreasing. Neutral ethereum.
5. P&L of investors: increased profitability of the coin supply and realised profits on-chain. Bullish ethereum.
6. Mining activity: hash rate and miner revenues start to recover. Bullish ethereum.
7. DeFi activity: TVL of ethereum is up the most over the past week at 8%. 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.

Dalvir Mandara is a Quantitative Researcher at Macro Hive. Dalvir has a BSc Mathematics and Computer Science and an MSc Mathematical Finance both from the University of Birmingham. His areas of interest are in the applications of machine learning, deep learning and alternative data for predictive modelling of financial markets.