The Ethereum Merge: Are Investors Backing Out?
- By Bilal Hafeez and Dalvir Mandara
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- 12 min read
Summary
Trading View (next 2-4 weeks): We like to be bearish ethereum.
Investment View (next 1-3 years): We like to hold ethereum.
Macro Signals
- The next FOMC meeting will likely deliver a rate hike of 75bps.
- Crypto markets are still feeling the effects of the crypto credit crunch.
- The probability of a recession remains above 50%.
- The macro backdrop is bearish for ethereum.
On-Chain/Flow Signals
- We have five bearish signals and two neutral signals this week.
Overall View
- With the macro backdrop bearish and on-chain/flow metrics very bearish, our overall signal is more bearish ethereum (Chart 1).
Blockchain Activity Is Falling
Rate hikes, a potential recession, and a negative macro backdrop in general have set the stage for a cumulative drawdown of over 70% for ethereum from the November 2021 highs. But how has activity on the blockchain fared throughout the extreme drawdown?
Network Growth Slows
One way to measure blockchain activity is to look at the number of active addresses. Crypto users have a unique address that identifies their wallet to ensure that transactions occur between intended addresses/users and are recorded permanently on the blockchain. Active addresses are unique addresses that have participated in a successful transaction on any given day.
Examining the total number of active addresses over time can provide one measure of network growth. Intuitively, more active addresses mean more usage of the blockchain, which would generally be a bullish sign. On the flip side, a decreasing number of active addresses means decreasing usage. We are currently seeing the latter: the number of active addresses is in a downtrend and currently at levels last seen at the end of 2020 (Chart 2).
Less ETH Is Being Staked for the Merge
The merge is now due around September. But delays have happened before, so the switch to proof-of-stake could extend into 2023 and beyond.
The amount of new ETH being transferred to the staking contract was rising rapidly until the start of May (Chart 3). This trend has been completely reset, however: the amount of new ETH transferred is down 71% over the past 14 days. There seems to be less interest in the merge amid drawdowns, despite the bullish implications it should have for ethereum. Combining this with decreasing active addresses, the falling hash rate, and plummeting miner revenues, we find the backdrop is bearish in terms of ethereum’s network activity.
Other Macro Drivers
The macro backdrop is bearish for crypto in general with the prospect of aggressive hiking paths from central banks and recession risks. We can add to this backdrop crypto’s own credit crunch – large crypto lending platforms like Celsius are suffering a liquidity crisis. And there are other factors, too:
- Goldman Sachs is reportedly looking to raise $2bn to buy Celsius assets if they go bankrupt.
- Voyager Digital has issued a notice of default to one of the most active crypto hedge funds, Three Arrows Capital (3AC). This comes after crypto lenders BlockFi and Genesis liquidated some of 3AC’s positions after a margin call.
- Harmony is the latest blockchain to be hacked. Hackers stole $100mn worth of crypto and exchanged it for ethereum.
On-Chain/Flow Metrics: ETF Outflows Resume
We have two neutral signals this week:
- Longer-term HODLer vintage decreases slightly.
- TVL in DeFi is historically low, but ethereum’s TVL increases over the past week.
The remaining signals are all bearish:
- ETF outflows resume.
- There is still a bias for exchange inflows.
- Futures open interest is historically low, and funding rates are negative.
- Reduced profitability of the coin supply and realised losses on chain.
- Hash rate and miner revenues decline.
On balance, on-chain/flow metrics are giving a very bearish 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. We have seen a return to ETF outflows (Chart 4), which we view as bearish for ethereum.
Demand for Liquidity and Exchange Activity: Bearish Ethereum
There is a persistent bias for exchange inflows. Net 35,000 and 867,000 coins entered exchanges over the past seven and 14 days, respectively (Chart 5). This is bearish 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 been rising since our last update and hit its highest levels since March 2020 (Chart 6). This is bearish ethereum.
Futures Activity: Bearish Ethereum
Futures open interest is now at lows last seen in March 2020 – it is currently around $4.6bn, down 17% over the past 14 days (Chart 7). Around $3.6bn (85%) of this comes from perpetual futures contracts. That is up 10pp since our last ethereum update.
Perpetual funding rates reveal the directional bias of investors. On average, they had been increasing but still sit below zero (Chart 8).
Overall, futures open interest is historically low, and funding rates are negative: this is bearish ethereum.
HODLers: Neutral Ethereum
The 30-day moving average of the coin days destroyed (CDD) has been trending down (Chart 9). This suggests less distribution of older coins.
However, splitting HODLers into those who have held for under one year and those for one year or more reveals some older hands are selling as the 1y+ vintage decreases slightly (Chart 10). This vintage was previously in a steep uptrend, but it looks as though we could be past the turning point as older hands start some selling.
On balance, we view these HODLer metrics as neutral ethereum.
Investor Profit and Loss: Bearish Ethereum
On profitability of the coin supply:
- The percentage of circulating supply in profit (PSIP) is now 50% (Chart 11). This means only half of the circulating supply of coins have a current price that is more than the price at which they last moved.
- Net unrealised profit/loss (NUPL) is -0.25 (25% of market cap) (Chart 12). This means that the overall ethereum supply remains at an unrealised loss. In other words, the total value of the supply at the price at which the coins were last moved (realised cap) is less than the current value of the supply (market cap). NUPL dropped as low as -0.5 (50% of market cap) on 18 June.
- Realised losses prevail on chain. Spent output profit ratio (SOPR) (price sold divided by price paid) remains below one (net losses) (Chart 13). Looking at the past 30 days, all have seen net losses. Further back, all but three of the last 60 days have seen net losses too.
Overall, these realised and unrealised profit and loss metrics are bearish for ethereum.
Mining Activity: Bearish Ethereum
The hash rate continues to decline sharply. It is down 14% over the past 14 days (Chart 14). Miner revenues have also plummeted – down 24% over the past 14 days (Chart 15). Decreasing hash rate and lower miner revenues are bearish for ethereum.
DeFi: Neutral Ethereum
Our latest Crypto Index Tracker revealed our DeFi Index was leading gains as crypto markets started to stabilise. The total value locked (TVL) in DeFi across all protocols is currently around $77bn – down 17% over the past 14 days. However, all chains in the top 5 by TVL are up in terms of their TVL on the week (Charts 16 and 17). Ethereum TVL is up 7%.
That ethereum TVL has increased is a good sign, but ongoing concerns around platforms like Celsius and the DeFi space in general provide a more negative backdrop. Overall, we view this as neutral 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: ETF outflows return. Bearish ethereum.
- Liquidity demand: bias for exchange inflows. Bearish ethereum.
- Futures activity: futures open interest and perpetual funding rates in a downtrend. Bearish ethereum.
- HODLer behaviour: longer-term HODLer vintage starts to decrease slightly. Neutral ethereum.
- P&L of investors: decreased profitability of the coin supply, a state of net unrealised losses, and a bias for realised losses on-chain. Bearish ethereum.
- Mining activity: hash rate and miner revenues are down. Bearish ethereum.
- DeFi activity: TVL of ethereum is up 7% on the week, but concerns around the DeFi sector remain. 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.