Executive summary

The Ethereum network recently went through its largest upgrade since The Merge. In this report, Rich shares his take on how this full transition to Proof of Stake (PoS) could impact yields, liquidity, and overall market opportunity.

The story for years has been the activity of central banks and their balance sheets, and the impact this has had on the market. Many have shown the correlations between the Federal Reserve balance sheet and the S&P 500. Still, others in crypto have suggested that this “de-basing” of fiat currency is a rationale for owning cryptocurrencies.

Without taking a stance on this debate, one thing is clear is that there is at least a correlation if not causation. If I look at a longer-term chart, over the past four years, one can see on the far left the rapid growth in central bank balance sheets – Fed in blue, PBOC in pink, ECB in dark green, and BOJ in yellow. The Fed and PBOC were in fact growing these balance sheet before Covid-19, but like many other things, Covid-19 accelerated trends already in place.

We can see the delayed effect on ether spot in light green. Just as the central banks grew balance sheets, ether was eventually pushed higher. As central banks bought more risk-free assets, those investors bought high quality fixed income, pushing others to junk bonds. Junk bond investors in turn bought more equities and equity investors ultimately turned to crypto. Ether was a popular choice among the TradFi crowd because there was a clear story for how several of these Dapps were disrupting a financial services industry that was well understood.

However, as we entered 2021 and until late 2022, central banks slowly removed this liquidity. It had the opposite effect of the stimulation in 2020 and we saw the most disruptive technology assets from crypto to Nasdaq-100 stocks to venture capital, all lose a meaningful part of the value without this source of abundant liquidity.

Image 1: US, China, Europe, and Japan central bank balance sheet change vs. Ether spot price (long-term)

The story of the removal of liquidity may be changing. If I zoom in on the chart above to focus on the last nine months, we can see both PBOC and BOJ have been adding a fair bit of liquidity. Then we got to March of this year when the Federal Reserve pivoted on a dime due to the deposit crisis at banks. We can see in blue how the steady downward march lower in balance sheet unwound several months of drain in a short time. In light green, we can see that ether was already responding favorably to the PBOC and BOJ, with another move higher on the Fed moves.

Image 2: US, China, Europe and Japan central bank balance sheet change vs. Ether spot price (short-term)

Within crypto, it has been a grudge match between bitcoin and ether for the last year. When tough times hit and as we have seen in previous crypto cycles – the so-called crypto winters – there is a preference for bitcoin and bitcoin dominance moves higher. In the good times, the market seeks riskier opportunities, and the bitcoin dominance falls.  Here I look at the ratio of bitcoin to ether spot and compare to the Global Financial Stress Index (GFSI). As financial stress moves higher, we can see bitcoin outperform; however, when GFSI retreats, ether starts to lead the way (ratio moves lower). There is a fairly tight relationship here. 

Image 3: Bitcoin vs. Ether relative performance compared to Global Financial Stress Index

In the past six months or so, the story for ether on a relative basis may be changing. One of the knocks on crypto for years has been the lack of cash flow unless you were a miner on a Proof of Work (PoW) blockchain. However, post the major ether catalyst last September (The Merge) in which the ether network transitioned from PoW to Proof of Stake (PoS), now holders of ETH would be able to earn a yield by staking as little as 32 ETH to validate transactions.

For institutions involved in crypto, this was a positive development, as now firms could earn a yield on their holdings for one, but also could develop more simple discounted cash flow models to value ether and other PoS crypto, potentially opening the door to a new set of investors that wanted to use more traditional means of valuation when considering these coins.

Not only could institutional investors earn a yield, but this yield is extremely competitive relative to other yields available in the market.

Image 4: Advertised staking yield for an institution looking to stake

Even smaller investors were able to stake their ETH to take advantage. If a smaller investor did not have 32 ETH to stake, they could join a pool that would aggregate and stake the ETH collectively. This was good in that it allowed smaller investors to also benefit, however, this aggregation came at a cost – lower yields on staking.  We can see in the image below, individual investors looking to stake their ETH are offered a much lower yield than the institutions above. The trade-off is that the institutions must have the skill to actively manage the staking whereas retail investors can set it and forget it. Yet, it comes at a cost.

For both types of investors, there was another cost – illiquidity. The staked ETH would be locked up for a time period that was not immediately clear to all. 

Image 5: Advertised staking yield for an individual pooling ETH to stake

This all changed in the past week or so. The Ethereum network went through an upgrade, called Shapella (an amalgamation of Shanghai and Capella). This was one of the largest upgrades in the network’s history. The upgrade consisted of a few Ethereum Improvement Proposals (EIPs) but most of the focus was on the execution layer (Shanghai) and the consensus layer (Capella). This upgrade completes the transition cycle to PoS.

There has been much debate on what the completion of this upgrade would mean for ETH. On the one hand, investors that had staked ETH and been locked up for many months would finally be able to withdraw their ETH.  On the other hand, there would be far more liquidity added into the network and more functionality for those willing to stake ETH in terms of various structured products. Thus, we could see more deposits. Which would win out?

Image 6: Bull vs. Bear debate in Ether

The early verdict is in as the price of ether spot has moved higher post the Shapella upgrade, jumping from 1870 to over 2100 at one point. 

Image 7: Ether spot price performance post Shapella upgrade

We can also see that deposits have outnumbered withdrawals over this early period, which is driving the price action we see in the spot, futures, and options markets. 

Image 8: Ether deposits vs. withdrawals post the Shapella upgrade

This harkens back somewhat to the price action post The Merge last summer. Many people, such as myself, saw the transition from PoW to PoS as a major positive catalyst. The combination of the ability to generate yield in a yield-starved world as well as the more positive environmental impact, were seen as a positive potential force for good in price.

However, that didn’t really happen. In fact, it fizzled quite a bit and managed to move lower from about 1600 down to 1200 over the next three months. Perhaps there was too much anticipation of the positive price action. Or perhaps more likely, this catalyst really didn’t occur because staking did not truly start until December 2022 when investors understood its practicality post-Merge. I have drawn vertical lines on the chart of spot price below to show The Merge and when staking finally began. We can see after staking began the spot price moved higher.

Of course, looking back at the charts above, central bank liquidity played a part on both the move lower and higher. Perhaps investors who were long ETH through this period are looking at the latest Shapella potential catalyst a little more cynically. 

Image 9: Ether spot performance after The Merge

That said, as staking has been taking off in 2023, institutions are getting more involved in Ether futures and options. I might argue that the CME Group Ether futures and options are the preferred vehicle for many institutions to do their hedging given the higher level of transparency and clearinghouse support – the institutions want more of post 2022, which probably had many asking “why bother?”

We can see that just as staking was taking off, and spot price was beginning to move higher, the open interest in the options market also began to move higher. Puts have outnumbered calls as perhaps investors are looking to spend some of their yield for a bit of a hedge in the event prices reverse.

Image 10: Ether options open interest

While it can be lumpy at times, we are seeing more and more volume in the options as well. We keep going through the cycle of higher highs in volume numbers telling me that the adoption of Ether options is gaining traction. 

Image 11: Ether options volume

This traction is most apparent in the futures open interest as the averages have moved steadily higher quarter after quarter indicating a steady progression as comfort levels and opportunities approve across the board. 

Image 12: Ether futures open interest

This all begs the question of what to do from here. Will we see a pullback post the catalyst, as we did after The Merge, with withdrawals outpacing deposits? There are those that fear this and therefore feel comfortable selling into the move higher we have seen in recent days. However, as I said, this completes the transition cycle to PoS and potentially creates higher yields, more liquidity, and more opportunity for institutions and sophisticated individuals alike.

My sense is there is still a bigger bull story to ether. The completion of this catalyst has tremendous potential. In addition, the big overhang of declining central bank liquidity at least seems to be neutralizing. Perhaps it will not be as much a driver in the next couple years as it has been in the last couple years.

But, I also do not think it is off to the races. I do think there will be withdrawals and those that want to sell into the rally as they access ETH that has been locked. I think institutions will want to continue to hedge any exposures as a way to reduce volatility. Thus, I see a move higher, but perhaps a begrudging higher move.

I have tried to take advantage of that by using a June split-strike butterfly.  The difference with a split-strike fly versus the traditional symmetrical butterfly is that if I move above my top strike, I will still lock in some gains.  As with the symmetrical butterfly, I will maximize my gains if I end up at the middle strike. The difference versus the broken wing butterfly is that I narrow the strikes from the middle to the top and not from the first to the middle. Hence, I am laying out some premium, which I risk, but I keep some upside. In the broken wing fly, I reduce the premium but if I go to the top strike, I have bigger losses.

Below is the expected return on a June 2200-2500-2700 butterfly. I risk 50 ticks of premium to make 300 ticks a the mid (250 net) for a maximum potential reward to risk of five to one. However, if I end up above 2700, I still make 100 ticks (50 net) so that I double my money.  My biggest risk is that I do not make it above the 2250 breakeven on this butterfly.

The butterfly is used instead of outright calls because I feel the pace of the move will be slower, with some investors selling all the way up. I feel this is the best possible reward to risk that I can create.

Image 13: Expected Return for ETH June 2200-2500-2700 split-strike butterfly

These are the Greeks for the split-strike fly. You can see that I am short Vega on this trade and actually earn time decay even though I spend premium. If I sit there that time decay flips from positive to sharply negative as the odds of getting to the midpoint reduce. This is my biggest risk. As a set-it-and-forget-it idea premised on the underlying catalysts and changes in central bank balance sheets, I feel the split-strike fly gives me a good chance to take advantage of the current set-up.

Good luck and stay vigilant!

Image 14: Option Greeks for June ETH 2200-2500-2700 split-strike butterfly

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The opinions and statements contained in the commentary on this page do 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. This content has been produced by [Data Resource Technology]. CME Group has not had any input into the content and neither CME Group nor its affiliates shall be responsible or liable for the same.


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