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Arthur Hayes: Predicting some possible price action from the Ethereum merger event

Arthur Hayes

Read this article in 27 Minutes

ETH may fall slightly around the merger and then rise on a deflationary trend.

Original title: "ETH-flexive"

Original author: Arthur Hayes

Original compilation: Katie, Odaily Planet Daily

The core theory of Soros, the American financial giant, "reflexivity theory "refers to the fact that there is a feedback loop between market participants and market prices, that is, market participants' perceptions of a particular market situation will influence and shape the development of that situation. Market participants' expectations affect market facts (fundamentals), which in turn shape participants' expectations. That is, participants, consciously or not, often play an important role in contributing to the future they predict. Their bias reinforces the tendency for prices to rise or fall as the future becomes a self-fulfilling prophecy.

I will apply this theory to discuss the Ethereum merger. The conclusion is: the merger itself is not affected by the price of Ethereum, and its success or failure depends entirely on the technology of Ethereum core developers.

The merge will bring about two changes

1. It will eliminate PoW ETH emissions per block (i.e. ETH paid to miners in exchange for the computing power they provide to maintain the network). Currently, these emissions total approximately 13,000 ETH per day. After the merger, the 13,000 ETH per day emissions from miners will be replaced by smaller emissions of 1000 to 2000 ETH People who spend ETH in exchange for more ETH by helping determine which ETH transactions are valid and which are not). These emissions will occur at the same rate regardless of the price of ETH and usage of the Ethereum network.

2. Each block will burn a certain amount of gas fees (meaning that the ETH used to pay these fees will be permanently withdrawn from circulation). This variable depends on network usage. Network usage is a reflexive variable, which I explain in more detail later.

Total ETH inflation = block emission - gas burning fee

I take the block emission as a constant under the current local conditions. Gas fees depend on network usage.

· Inflation = block emission > gas fee

· Deflation = block emission < gas fee

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Those who believe that ETH will be a deflationary currency must also believe that network usage (and thus, fees paid by users to consume ETH) will be high enough to offset every block emission ETH as rewards for validators. However, to assess whether they might be right, we must first ask — what determines the usage of a cryptonetwork like Ethereum?

Users have many options when it comes to choosing an L1 smart contract network chain. Other L1 chains include Solana , Cardano, Near, etc. The following are the factors that I think influence users to choose the L1 chain:

1. Market participants’ views on the market situation;

2. Applications: Which network has the most robust Dapps? Which of these applications are leading the way? Which of these apps has the greatest trading liquidity?

Market participants’ prediction of the situation

There is a reflexive relationship between media publicity ratio and ETH price. The graph above shows Ethereum Google search trends and Ethereum price. It can be seen that they are closely related. If I run a correlation between the two data series, r = 0.77. Conceptually, this makes sense. Interest in the Ethereum network ebbs and flows with the price of its native token — as the price rises, more and more people hear about Ethereum and want to buy and use the network, further driving the price up.

Application

The quality of applications on the network depends on the quality and quantity of network engineers. As a developer, you create things for people to use. If no one is using the web, you're less likely to use it for development. Obviously, developers want to write code in a language they are familiar with, but this preference is secondary to the number of users that can interact on a given decentralized network.

The number of developers is directly related to the number of users their work can serve. As we established above, the number of users of a given network is directly related to the price of the native token. Because the number of users and price share a reflexive relationship, the number of developers and price must also share a reflexive relationship. As the price rises, more people hear about Ethereum, more people use the network, and more developers are drawn to build applications on the network, attracting a large and growing Growing user base. The better the application, the more users will join the network.

Two Possibilities of the Future Encryption World

·ETH Deflation The degree depends on the gas fee burned.

· The amount of the gas fee depends on the usage of the network.

· Network usage depends on the number of users and the quality of the application.

· There is a reflexive relationship between the number of users and the quality of the application and the price of ETH.

Therefore, according to the transitivity, there is a reflexive relationship between the deflation rate and the ETH price. With this in mind, there are two possibilities for the future of the crypto world.

If the merger occurs:

If the merger is successful, the price and the amount of currency deflation There is a positive reflexive relationship. So traders will buy ETH today, knowing that the higher the price, the more the network will be used, the more deflationary it will become, driving the price up, causing more use of the network, and so on. This is a virtuous circle for the bull market. A ceiling occurs when everyone has an Ethereum wallet address.

If the merger does not happen:

If the merger is not successful, the price and the amount of deflation There will be a negative reflexive relationship between them. Or, to put it another way, there will be a positive-reflexive relationship between prices and monetary inflation. So in this case, I think traders are either short or not holding ETH.

There is a bottom line to this relationship as the network is the longest operating decentralized network. ETH gained massive market cap without consolidation. The hottest Dapps are built using Ethereum, which also has the most developers of any L1 chain. As I mentioned in my previous post, I don't believe the price of ETH will fall below the $800-$1000 it experienced during the TerraUSD or Three Arrows Capital crypto credit crash.

Market Opinion

We now need to determine whether the market is The perception of failure.

In my opinion this can best be answered from the chart below which shows the ETH/BTC ratio. The higher the ratio, the better ETH outperforms Bitcoin. Since Bitcoin is the reserve asset of the crypto capital market, in my opinion, if ETH outperforms Bitcoin at this stage, it means that the market believes that a successful merger is more and more likely.

Since the crypto credit crisis, ETH has outperformed BTC by about 50%. So I think it's reasonable to assume that the market is increasingly confident that a successful merger is on the horizon. The current expected merge date proposed by Ethereum core developers is September 15, 2022. But this is just the point of view of the spot market. What about the perspective of derivatives traders?

The graph above illustrates the term structure of ETH futures. The futures term structure plots the current price of a futures contract against the time to expiration. It allows us to forecast supply and demand conditions for different maturities by calculating the premium or discount of the futures contract relative to the underlying spot price.

· backwardation = futures price < current spot price; discounted futures trade

· futures price > current spot price; futures premium Trading

Given that the entire curve through June 2023 is in backwardation, this means that the futures market is predicting that the price of ETH will be lower by the expiry date at the current spot price. On margins, selling pressure outweighs buying pressure.

This is a chart of ETH futures open interest. Open interest is the total number of open futures contracts held by market participants at a given point in time. As you can see, it is recovering from its lows during the crypto credit crash in mid-June. The curve is in backwardation while the open interest is increasing. In my opinion, this means that the selling pressure is increasing. Conversely, if the curve is in contango (futures price > current spot price), the amount of open interest increases, which would indicate significant and rising buying pressure on the margin.

Two of the current selling pressure Potential reasons

· You are long ETH but not sure if or when the merge will succeed Happens, so you fully or partially hedge your ETH exposure by selling futures contracts at a price above the current spot price.

· You want the merger to happen, and you want to be able to get a free public chain split Token, when some related ETH When tokens resist merging and create a fork to maintain the ETH PoW chain, these tokens will be minted and distributed to all ETH holders. So, you are long Ethereum, but you also want to hedge your exposure to Ethereum by selling futures contracts. If you sell the futures contract at a discount to the value of the chainsplit token you received, then you can make a profit.

But remember I just showed that ETH outperformed BTC by 50%. Selling by market makers in the spot market is no match for the long-term flow of bulls. This means that market confidence in a successful merger is undervalued and overshadowed by short-hedging liquidity from market makers.

If the market thinks the odds of a merger happening are increasing every day, what happens to those who are hedging through futures contracts if the merger succeeds?

1. If the merger is successful, those who hold ETH spot will buy back their hedge so they can get benefit from the positive reflexivity described above.

2. If the merger is successful, and the Tokens of the public chain split are distributed, they will be sold at any value, and those who hedge their positions The position will be closed immediately. Now, they may decide to sell spot ETH and close out their positions completely, but I bet these traders will be in the minority. The possibility that ETH could benefit from positive reflexivity will be discovered.

I think a successful merger will create some buying pressure, reversing market makers' futures positions in the process. They will switch from being long/short in futures to being short/long in futures. The spot they are short has to cover (which means buying spot), and if they are net short futures, they must now go into the market and buy additional spot. The unwinding of derivative flows that resulted in backwardation prior to the consolidation will result in contango post-consolidation.

Decision to deal

For those who believe the merger will go through as planned Humans, the question becomes: how do you express your bullish view?

Spot/ETH

The most direct transaction is to buy ETH with legal currency, or in Add ETH to your crypto portfolio.

Lido Finance

Lido Finance is the largest Ethereum Beacon Chain validator . Lido allows players to stake ETH to earn validator rewards. In return, Lido will receive a 10% reward in ETH. Lido has a DAO that issues Tokens - LDO.

This is an attractive option if you want to take on more risk of consolidation. It's riskier than owning spot ETH because Lido's value proposition is entirely dependent on the success of the merger - whereas with spot ETH, it might still be successful because it has other value propositions (i.e. powering the second largest public chain by market capitalization) ).

LDO is up more than 6x since the crypto credit crash in mid-June as the combined beta is higher.

Long ETH Futures

For those who want to gain more income by increasing leverage trading For people, long ETH futures is a good choice. Since the basis is negative, those who hold long futures are rewarded by holding exposure to ETH.

Basic=futures-spot

From the perspective of term structure, from December 2023 to Long-term futures contracts are the cheapest. If the merge succeeds, due to the remaining time value. Futures contracts expiring in September 2023 still have 1-2 weeks of time value after combining, and you won't get the same basis effect as if you were long December futures.

Long ETH Call Option

For those who like leverage but don't want to imagine Buying call options is a good strategy for those who worry about being liquidated like futures contracts. Implied volatility for September and December futures is currently lower than realized volatility. This is expected since hedgers use not only futures contracts but also options.

Interestingly, when I entered the market to buy a December 2022 $3000 ETH call option, I was able to trade a much larger Quote to trade. I've been told this is because traders have a lot of long call options and hedgers are hedging their long ETH positions with long coverage. Traders are more than happy to reduce their long call exposure as this frees up margin and they are showing very tight prices on offer.

Similar to the futures term structure, the implied volatility of December options is lower than that of September options. Another reason I prefer the 12/12 call is because I don't need to be as precise on the timing of the consolidation. While the developers tell us the merge is September 15th, the technical delivery date is known. I don't want to worry about having a few weeks off on the merge completion date.

Long December futures VS. Short September futures

This It's a curvilinear approach. You need to watch your margin very carefully. While you have no exposure to the ETH price, you will be showing unrealized losses on the one hand and unrealized profits on the other. If the trading platform in question does not allow you to offset these losses, then you will have to margin call the losing portion of the trade, otherwise, you will be liquidated.

Buy the rumour, or sell the truth?

Assuming you are long via some ethereum-related instrument, the question becomes - do you fully unload before the merger happens or Close a position?

Because of the positive reflexivity that drives up the price of ETH before the merger, "Textbook trading: It is recommended that you should at least reduce your holdings before the merger. However, the reality Rarely does it live up to expectations.

However a structural drop in inflation will only happen after the merger. I hope we see something similar to the Bitcoin halving .That is, we all know the dates they will happen, but Bitcoin still bounces after the halving.

That is, the price of ETH has May drop slightly post-merger. Those who cut some or all of their positions will initially be happy with their decision. However, as deflation begins, due to the reflexive relationship between high and rising ETH prices and network usage , the price may grind higher. At that point, you have to decide when to get back into your position. This is often a very challenging trading situation. You believe in the long-term trend but want to trade around your position. Now, you have to pay a higher price to re-enter the position. But you're always waiting for a dip when you know it's time to buy back. But that dip, or at least the magnitude of the dip you were expecting, never happened, and you either never re-entered the same position, or you missed out on a significant portion of your gains.

With this thought experiment in mind, and my belief in the reflexive nature of the situation, I will not lower my positions before and after the merge. But I will add to my position when the market sells off because I believe the best prices are yet to come.

How to dump

To think deeply, we also have to consider shortening the merger The best strategy for the time of occurrence. Given the current market sentiment and price action, those who were shorting ETH ahead of the merger are fighting a reflexive trade. This is a very dangerous situation. When you short something, your maximum gain is 100% unaffected because the price can only go to zero (while the maximum loss on the way up is unlimited). Therefore, timing is very important.

The best time to shorten the time is before the merge takes place. That's going to be when expectations are highest, you have a short period of time between entering a deal and when the merger happens or doesn't happen. If the merger fails, the sell-off will be swift, given the market's high expectations and objective reality. This way you can exit the trade quickly with a profit.

I recommend using put options. Referring to the futures curve above, March 2023 futures have the smallest discount. This means that, as a short, you pay the least. This also means that the March 2023 put option will be the most attractive. If I were short, I would buy 1000 ETH puts on September 14, 2023. You know in advance your maximum loss, which is the put premium. This will allow you to eliminate unlimited losses if the merge is successful. Your downside target is a quick move below $1,000.

Summary

This article helped me really think about my trading and Ultimately boosting my confidence in my portfolio positioning. If I can't rationalize the thinking behind my portfolio, then I need to reexamine my trading decisions. In the course of writing past articles, I've made major changes to my portfolio and lost faith in previously held beliefs because I couldn't defend them well in written words.

I tried to apply Soros's theory of reflexivity to the ETH merger, which increased my confidence. I questioned what I was supposed to be doing to lead the merge, and after putting those thoughts on paper, I knew that copycats were always going to be the theme.