Chaotic market after Ethereum merger

Article author: Dessislava Aubert, Conor Ryder, CFA, Riyad Carey, Clara Medalie | Article compiler: Block unicorn

Trend this week

With the increase of selling pressure and the departure of miners, the price of ETHW (the forked token of Ethereum) plummeted.

The proof of work of Ethereum was not very smooth at the beginning. The token ETHW, which represents the new hard forked Ethereum network, has fallen by more than 80% since FTX was listed. Due to the failure and the emergence of a competitive branch called EthereumFair, the overall poor launch of the network has further deteriorated, which is supported by the exchange Poloniex.

At the same time, as one of the first hard forked Ethereum networks, with the transition of miners to ETC mining after the successful completion of the merger, the hash rate has increased dramatically. Ethereum Classic diverged in 2016, but failed to gain significant market share or utilization rate for many years. ETC fell 25% this week, and its liquidity in the centralized exchange is very poor, which may cause problems for new miners who want to cash out.

If the miners sell their ETCs in the spot market, they will see a drop of nearly five times in the sales order of a $100000 market compared with the sales of ETH. This additional cost is the next in a series of problems faced by ETH miners in the future, because they strive to maintain relevance, and the most important thing is to maintain profitability.

1. Price change

The combined selling swept the market

In a week when many people expected the price of Ether to be positive, a successful merger ended a week of substantial selling of about 25%. ETHW and ETC are also some of the worst performers this week, which indicates that the old Ethereum miners will be difficult to maintain profits. In the broader industry news, the Korean court issued an arrest warrant against Do Kwon, the founder of Terra. The Blockchain Association established an industry PAC, and Wall Street companies Charles Schwab, Citadel Securities and Fidelity Digital Assets announced the launch of the new cryptocurrency exchange EDX Markets.

ETH discount rate narrowed to the lowest level since May

The discount of pledged ETH tokens compared with spot ETH has narrowed to the lowest level since May. This trend first appeared a few hours after the successful transition of Ethereum Network to Proof of Rights. For example, the cbETH of Coinbase, the bETH of Coinsecurity and the stETH of Lido are the packaging versions of the pledged Ether on the Ethereum consensus layer (Beacon chain). They are not linked to ETH, and their market prices take into account some regulatory and smart contract risks. For example, if the verification node has a problem that is not good, the verification node will be "punished" by the Ethereum network, and the tokens involved in the punished Ethereum pledge nodes may be at risk.

Lido's stETH discount has narrowed significantly from 4% to only 1%, thanks to the increased liquidity of Curve's stETH pool, which is the largest secondary market for pledged Ether. The cbETH and bETH markets also saw strong buying pressure immediately after the merger (we will discuss the market reaction after the merger here). Although this trend shows that some risk premiums have been eliminated, the ETH discount of pledge may continue until the next Ethereum upgrade next year allows pledge withdrawal. However, the opportunity cost of holding ETH has now increased (because pledge provides additional benefits), which may provide some favorable factors for acquiring shares in the ETH market.

2. Market liquidity

The US dollar remains the dominant legal tender in cryptocurrencies

Although most cryptocurrency transactions are conducted using stable currencies, fiat is still the key channel to enter and exit the market. Historically, the US dollar has always been the most important legal tender in cryptocurrencies, but what changes have taken place in its role over time? Since 2018, the share of bitcoin transactions against the US dollar has increased significantly, and the US dollar now exceeds 70% of the bitcoin transaction volume.

This trend can be explained by the increasingly institutionalized market, because large investors usually prefer to trade in dollars. However, a careful observation of the classification by fiat currency shows that local supervision may also play a role. It is worth noting that the bitcoin trading volume on the Japanese market has declined significantly. After being attacked by hackers of US $97 million and more stringent supervision in Japan, the annual trading volume of Liquid on the Japanese Exchange has decreased by five times between 2018 and 2021. In contrast, Bitcoin transactions in the US dollar market increased by 30% over the same period.

As the regulatory system around the world becomes clearer, the market share of stable currencies may continue to develop. For example, it is reported that Japan is considering relaxing the review regulations on new assets. At present, the dollar is still the hegemon.

During the sell-off period after the merger, ETH's market share reached a record high

The market share of Ether trading volume reached a record high in the combined selling last week, approaching 70% of Bitcoin trading volume. The large-scale closing of leveraged long positions in the derivatives market exacerbated the decline in spot prices, resulting in a surge in spot trading volume. In general, ETH's market share has more than doubled since 2020, indicating that the market structure is shifting from BTC to another market.

With the surge of trading volume, the liquidity of ETH spot market evaporated, measured by the buying and selling volume within 2% of the middle price in ETH USD (T) orders. This indicates that market makers feel uneasy and have reduced liquidity to avoid falling into merger related volatility. After the merger, the liquidity increased rapidly, and the current level is only slightly higher than the level before the merger.

Although the performance of Ethereum YTD (year to date) continues to be slightly weaker than that of Bitcoin, although the macro environment is full of challenges, it is expected that the decline in its issuance may support its price.

Currency security has changed the trend of transaction volume

Trading volume is one of the best indicators of a long-term bear market. The initial price decline is usually accompanied by a surge in trading volume, as traders take advantage of (or suffer from) fluctuations. However, as days turned into weeks and months of depressed prices, trading volumes on most exchanges began to decline. However, when observing the aggregate trading volume of the most liquid BTC and ETH currency pairs, we can observe that there has been no such trend since the bear market began in May. Although the weekly trading volume is still far below the historical high, there has actually been a slight increase in activity in the past few months.

Unfortunately, aggregated data can confuse trends at the exchange level. When separating the currency security from this aggregate data set, we can see that the activities of the world's largest exchange are very different from those of the other 13 exchanges. Since Coin Security cancelled the transaction costs of Bitcoin/ETH pairs, the transaction volume of Bitcoin/ETH pairs has soared. For the first time, the market share of Yen An far exceeded the total trading volume of the other 13 exchanges (including Coinbase, FTX, Huo Coin, Okex, etc.). Since the beginning of 2022, the trading volume of all exchanges except the currency security has actually shown a downward trend, which is in line with our expectations for the bear market.

The transaction cost of canceling the most liquid currency pair is not affordable by most exchanges, so we may expect this trend to continue until the market adjusts.

3. Derivatives

ATOM's open position equity surged in the bullish market

In the months when the price of cryptocurrency was low, Cosmos token ATOM was one of the few highlights. Cosmos is a decentralized network composed of independent and interoperable blockchains. It aims to become a "blockchain Internet", enabling them to share data and tokens in their ecosystems.

ATOM has risen by more than 40% in the past four days, although the token has fallen by 54% so far this year (competitors such as SOL and AVAX have fallen by 82% and 85% respectively). After the collapse of Terra, a part of the Cosmos ecosystem, other projects began to replace its activities, including Kava, Osmosis and Thorchain. In addition, it is widely expected that the team will soon announce ATOM's new token economic model, which will reduce inflation and increase the usefulness of tokens. Among these positive catalysts, the open position contract has soared from less than 50 million dollars in mid June to more than 200 million dollars now. Since the beginning of September, the average financing rate has been on the rise, which indicates that the recent surge in open positions is biased towards bulls.

The financing interest rate of ETH rose sharply

With the beginning of ETHW airdrop, the interest rate of ETH funds has risen sharply from the historical low point after the merger, and futures prices no longer need to consider potential arbitrage. Investors use ETHW air drop to combine their ETH long spot position with ETH short futures position to eliminate price risk, while still being able to collect ETHW air drop. If futures prices are not discounted to reflect this strategy, this strategy will also benefit from short futures trading. Once the merger is successfully completed, the air drop of ETHW occurs, and the futures return to close to the spot price, so the capital interest rate moves sharply to neutral again.

4. Macro trends

Higher than expected US inflation has intensified the Federal Reserve's bet on raising interest rates

The macroeconomic headwinds continue to put pressure on financial markets. Previously, the inflation rate of the United States in August was higher than expected, leading to the sharp drop of cryptocurrency and stock market. The overall inflation rate rose 8.3% year on year, slightly lower than the data in July. However, core inflation rose 0.6% in the month, almost twice the expected rate. Core inflation does not include food and energy prices with large fluctuations, and is considered to be more viscous and hedging cost than overall inflation and energy inflation. Fearing that the process of reducing inflation will be slower and more painful than expected, the Federal Reserve has significantly adjusted the maximum interest rate currently higher than 4%. The market generally expects the Federal Reserve to raise interest rates by 75 basis points again at this week's meeting, and the bet that the Federal Reserve will raise interest rates by 75 basis points is also increasing.

The correlation between Bitcoin and bonds and stocks rose in September

The correlation between Bitcoin and bonds and stocks recovered in September after falling in the summer. The uncertainty of inflation and the tightening policy of the Federal Reserve have led to a historic decline in both risk and fixed income assets, posing a challenge to the traditional asset allocation method. The iShares Aggregate Bonds ETF, which tracks the US investment grade bond market, has fallen by 12% this year, the NASDAQ 100 index has fallen by 28%, and Bitcoin has fallen by more than 50%. Recent research shows that the continued high and more volatile core inflation may be one of the explanations for the positive correlation between bonds and risky assets in the past few months, because inflation has a negative impact on all asset classes.