The Shanghai Upgrade: What It Means for Ethereum Prices

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

• US nonfarm payrolls was as expected and consistent with continued strong expansion.
• Markets are pricing in around a 70% chance of a hike at the 3 May FOMC meeting – we agree.
• The probability of a recession remains over 90%, according to the inversion of the 2s10s curve.

On-Chain/Flow Signals

• We have five bullish signals and one neutral.

Overall View

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

How Will the Shanghai Upgrade Impact Ethereum Prices?

Shanghai upgrade incoming. In September last year, the ethereum network successfully transitioned from a proof-of-work (PoW) consensus protocol to a proof-of-stake (PoS) one. That meant ditching the energy-intensive mining process in favour of staking to confirm transactions on the blockchain. The next upgrade (the Shanghai upgrade) is due tomorrow (12 April) and will enable validators to withdraw their staking rewards.

Another update called Capella is happening in parallel, and the two are often merged under the name ‘Shapella’. Together, the two updates significantly change both the execution layer and consensus layer of ethereum.

Over $34bn in ETH will be unlocked. Currently, over18mn ETH(c. $34bn, Chart 2)is locked up on the ethereum network. After tomorrow’s upgrade, validators will be able to send withdrawal requests for their staking rewards.

There are several scenarios for how this effects ethereum prices in the short to medium term:

• Ethereum sells off. If a significant proportion of validators were to claim their staking rewards and sell the staked ETH immediately after the upgrade, a sell-off could be triggered.
• Nothing happens. If selling staked ETH is the motivation, users have been able to do so via liquid staking token providers (e.g., LIDO) for some time. So, it could turn out to be a non-event because the ability to sell the staked ETH is already priced in.
• Ethereum rallies. The prospect of being able to withdraw staked ETH from the ethereum network may make more people willing to stake ETH. This would further reduce the liquid supply of ETH and would be bullish for ethereum overall.

A combination of the above three outcomes is likely over the short to medium term. But we lean towards a limited impact on prices in the short term. For one, there is a withdrawal queue mechanism, and not everyone will be able to withdraw their staked ETH immediately after the upgrade. Yet we see a bullish impulse longer term.

Macro Backdrop: Inflation Risks Remain

Friday’s US employment data suggested continued strong expansion. March nonfarm payrolls (NFP) at 236,000 aligned with expectations of 230,000. Employment growth continued to slow YoY but remains twice as fast as before the pandemic and 1.5 times faster than labour supply.

Yield curve indicators are flashing red. Yield curve inversions have historically been one of the best predictors of recessions. The current spread between US 3M and 10Y yields sits at -167bps, the deepest ever. Consequently, the probability of a recession as determined by the inversion remains high. On the other hand, equity markets disagree, and Dominique is on the side of the equity markets and does not see a recession coming.

Markets are pricing in a 70% chance of a hike at the 3 May FOMC meeting, and we agree. We believe the backdrop for next month’s FOMC meeting is likely to be continued banking stability – the latest Fed balance sheet data showed further stabilisation as lending to banks continued to decrease.

The Fed is likely to focus on inflation risks against a backdrop of continued banking sector stability. The latest NFP data show inflation risks remain substantial. And if CPI comes out at +40bps MoM in line with consensus, a 25bp hike next month seems likely.

The macro backdrop is bearish to neutral for ethereum.

On-Chain/Flow Metrics: Exchange Outflows Dominate

We have five bullish signals this week:

• Liquidity demand: exchange outflows.
• Futures activity: futures open interest is up MoM and funding rates are positive on average.
• HODLer behaviour: 63% of the coin supply has not moved in at least a year.
• P&L: the profitability of the coin supply is rising and realised profits dominate on chain (SOPR > 1).
• DeFi: total value locked in DeFi for ethereum is rising.

The remaining signal is neutral:

• Institutional demand: ETF inflows are muted.

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

Institutional Demand: Neutral Ethereum

Our preferred metric to track institutional demand is flows into ethereum ETFs. The year so far has had a bias for outflows, though flows have been small in magnitude compared to recent history.

More recently, inflows have returned with around $3mn entering the ethereum ETFs we track over the past five days (Chart 3). That inflows have returned is a positive sign for ethereum, but we would need to see these sustained over a longer period and higher in magnitude to reconfirm a bullish signal from this metric. For now, this is neutral for ethereum.

Demand for Liquidity and Exchange Activity: Bullish Ethereum

On exchange flows:

• Short term, a slight bias exists for exchange inflows exists with net 3,400 coins entering exchanges over the past week (Chart 4).

• Longer term, the 30-day change in the exchange flipped to negative on 10 February and it has remained in negative territory ever since (Chart 5).

On balance, the longer term bias for exchange outflows is bullish for ethereum.

Futures Activity: Bullish Ethereum

On futures markets:

• Futures open interest, a good proxy for investor interest, is currently around $5bn – up 21% MoM (Chart 6).

• Perpetual funding rates remain positive on average, meaning traders are paying a premium to keep open long positions (Chart 7).

That futures open interest is up MoM and funding rates remain positive is a bullish sign for ethereum.

HODLers: Bullish Ethereum

On HODLer metrics:

• The 30-day moving average of the coin days destroyed (CDD) metric is down 10% MoM (Chart 8), suggesting reduced movement of older coins.
  
  
• Splitting the entire coin supply into those who have held for under one year and those for one year or more reveals the latter vintage shows no signs of abating yet with 63% of the coin supply having not moved in at least a year (Chart 9).

A significant proportion of the ethereum supply remains dormant. Indeed, over 60% of the supply has not moved in at least a year which points to a strong investor base that continues to hold despite ongoing macroeconomic and regulatory headwinds. This is bullish for ethereum.

Investor Profit and Loss: Bullish Ethereum

On profitability of the coin supply:

• The percentage of circulating supply in profit (PSIP) is 77% (+18bps MoM, Chart 10).

• Net unrealised profit/loss (NUPL) is now 0.26 (26% of market cap, +20bps MoM, Chart 11). This means that the overall ethereum supply remains in a state of unrealised profit (NUPL > 0) as market cap exceeds realised cap.

• The spent output profit ratio (SOPR, price sold/price paid) has maintained a bias for levels above one (realised profits) this year (Chart 12). Year to date, 81% of days have seen realised profits. Furthermore, over the past 30 days, every single day has had a SOPR value above one.

The profitability of the coin supply is rising again, the supply is in an overall state of unrealised profit (NUPL > 0) and realised profits on-chain (SOPR > 1) dominate. Overall, this is bullish ethereum.

DeFi: Bullish Ethereum

Of the top five DeFi protocols by total value locked (TVL), ethereum’s TVL is up the second highest at +5% WoW, after Tron’s TVL which is up +6% WoW (+1% WoW, Charts 13 and 14). All other chains in the top 5 by TVL are also up in terms of their TVL between 2% and 4% each. The increase in ethereum’s TVL is bullish.

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 Head of Research at 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.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)