Will the Merge Be Bullish for Ethereum?
- By Bilal Hafeez and Dalvir Mandara
- 12 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
- Hawkish Fed minutes from the March policy meeting were released.
- Ethereum and equity correlations remain above 80%, with both markets sliding on the Fed minutes.
- Risks remain around the Russia-Ukraine war and a potential recession.
- The macro backdrop moves from neutral to bearish.
On-Chain/Flow Signals
- Bullish signals across five of our seven metrics, with the other two giving neutral signals.
Overall View
- With the macro backdrop bearish but on-chain/flow metrics still very positive, our overall signal is neutral ethereum.
Macro: The Merge and Monetary Policy
With Q2 underway, we are approaching an important and highly anticipated update to the ethereum ecosystem – the official switch to proof-of-stake (PoS) consensus. Currently, the ethereum Mainnet uses a proof-of-work (PoW) consensus protocol. The Beacon Chain is a separate chain that runs in parallel to the Mainnet that uses PoS. The Merge, due in Q2 2022, is when the two chains come together and ethereum officially switches to PoS.
In PoS, validators replace miners. To become a validator, users must stake 32 ETH to the ethereum staking contract. The total value staked is currently around $39bn (Chart 2). And the amount of new ETH being staked daily (on average) has been in a steep uptrend since 22 February (Chart 3). Having many validators ensures ethereum can maintain a decentralised consensus.
What are the consequences of the Merge for ethereum prices? How will ethereum’s monetary policy change, and how will this affect its outlook? This week, we investigate the possible implications of the Merge for ethereum.
What Is the Impact of the Merge?
The Merge brings with it changes to ethereum’s monetary policy. We look at various aspects and what they might mean for ethereum:
- Earn yield on staked ETH: validators will earn interest on their staked ETH as a reward for their participation in the network. The prospect of making a passive return on staked ETH will likely attract more investors into the space.
- Net issuance will drop considerably post-Merge: the amount of ETH issued is projected to drop by 90% since the block reward is replaced by offering yield on staked ETH. If demand continues to rise, this reduction in supply should be bullish for ethereum.
- Increased scalability and security: ethereum handles 15 transactions per second at the moment. Post-Merge, this is expected to rise to 100,000 transactions per second. This will alleviate much of the scalability concerns around ethereum and encourages more applications.
- Ethereum may become deflationary: staked ETH coupled with the ongoing ETH burning introduced in EIP-1559 will likely make it deflationary.
- ESG concerns alleviated: post-Merge, the energy usage of ethereum will drop considerably as it ditches the energy-intensive PoW paradigm for PoS. This may attract more institutional money into the space.
Overall, we believe ethereum’s upcoming Merge should have bullish implications for ETH.
On-Chain/Flow:
We have five bullish signals this week:
- ETF inflows.
- Significant bias for exchange outflows.
- Futures open interest rising and funding rates positive.
- Increased profitability of the coin supply and realised profits on-chain.
- Hash rate and miner revenues increasing.
The two remaining signals are neutral:
- Some longer term HODLers are selling but most of the coin supply is still accumulating.
- Ethereum’s total value locked (TVL) in DeFi decreases week on week but it still maintains the largest share of total TVL.
On balance, on-chain/flow metrics are giving a bullish signal for ethereum (Chart 1). 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. Since our last report, we have seen a sustained period of ETF inflows (Chart 4). Net inflows have been decreasing in magnitude recently but remain positive, so we view this as a bullish sign nonetheless.
Demand for Liquidity and Exchange Activity: Bullish Ethereum
In the short term, a large bias for outflows from exchanges exists. Net 866,000 and 210,000 coins left exchanges over the past 14 and seven days, respectively (Chart 5). On 29 March alone, we saw net outflows of 305,000 coins. This is the second-largest number of coins exiting exchanges on a single day since 2 July 2021. 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. Relative to the last 30 days, the exchange balance is in a deep downward trend (Chart 6). We saw similar behaviour during the bull run between July and September in 2021 and between October and December 2021 (during which, the all-time highs were set). Notably, this metric hit around -1.3mn ETH during the run up to the all-time highs in November 2021, and it is currently even lower at around -1.4mn ETH. Lastly, only 17% of the total coin supply currently sits on exchanges. This is bullish ethereum.
Investors have an increasing preference to keep their ethereum holdings off exchanges. Overall, this is bullish ethereum.
Futures Activity: Bullish Ethereum
Futures open interest is trending up – it is currently $9.1bn, up 10% over the past 14 days (Chart 7). Around $7.4bn (81%) of this comes from perpetual futures contracts, so a large majority of leverage sits in perpetuals.
Perpetual funding rates reveal the directional bias of investors. They are currently in a broader uptrend. On average, they have been positive every day over the past week (Chart 8). Additionally, they have been positive for all but one day over the past 14 days. This is bullish ethereum, as it means investors are paying a premium to keep open long positions.
Overall, futures open interest mostly sits in perpetuals, which have a bias for positive funding rates. This is bullish ethereum.
HODLers: Neutral Ethereum
The 30-day moving average of the coin days destroyed (CDD) metric still shows little movement of older coins (Chart 9). Splitting HODLers into those who have held for under one year and those for one year or more reveals some older hands have indeed sold – the 1y+ vintage drops from 62% to 57% of the coin supply (Chart 10). This suggests around 5% of the coin supply in the 1y+ vintage has moved into the <1y vintage. This is somewhat expected as some older hands distribute some of their holdings into market strength to realise profits. However, most of the coin supply is still accumulating.
On balance, we view these HODLer metrics as neutral ethereum.
Investor Profit and Loss: Bullish Ethereum
The percentage of circulating supply in profit (PSIP) is now 87% (Chart 11) – up 8pp over the past 14 days.
Net unrealised profit/loss (NUPL) is now 0.52 (52% of market cap) (Chart 12) – up 7pp over the past week. This has been above 0.5 since 27 March, and we will watch to see if it can keep rising to confirm a longer-term bullish sentiment.
SOPR has remained above one since 17 March (Chart 13). This suggests a significant, recent bias for realised profits on-chain. With some older hands (1y+) selling, this is somewhat expected. More profits on-chain is generally a bullish signal. However, excessive profit taking (extreme spikes in SOPR) and increased sell-side pressure can also precede a correction (as during the November 2021 all-time highs). We will therefore be watching this closely.
Mining Activity: Bullish Ethereum
The hash rate resumes an uptrend and continues to set new all-time highs (Chart 14). It is currently up 2% over the past 14 days and 11% year to date. Miner revenues are rising sharply – they are up 75% over the past 14 days (Chart 15). Together, these metrics are bullish ethereum.
DeFi: Neutral Ethereum
DeFi markets have been leading gains amid regulatory efforts from the EU and the SEC to combat money laundering in crypto. Our latest Crypto Index Tracker revealed our DeFi Index is up the most (17%). The total value locked (TVL) in DeFi across all protocols is currently around $230bn – this is up 8% over the past 14 days. We have seen an increase in TVL across all the top five chains (Charts 16 and 17) except ethereum, which is down just 1%. However, it is still the dominant player in the space with $124bn TVL, eclipsing the next highest, Terra, with $33bn TVL. On balance, we view this as a neutral signal for 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: sustained ETF inflows. Bullish ethereum.
- Liquidity demand: a large bias for outflows from exchanges. Bullish ethereum.
- Futures activity: increasing futures open interest and positive perpetual funding rates. Bullish ethereum.
- HODLer behaviour: some longer-term HODLers selling but most of the coin supply still accumulating. Neutral ethereum.
- P&L of investors: increased profitability of the coin supply and realised profits on-chain. Bullish ethereum.
- Mining activity: the hash rate and miner revenue increasing. Bullish ethereum.
- DeFi activity: TVL increasing across all top-five chains except ethereum, but ethereum’s TVL still claims the largest share of the entire DeFi TVL. Neutral 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.
Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.
Great info here, thanks Bilal !