One of the most anticipated and important developments in crypto history is happening in September. The Ethereum merge will affect the second largest blockchain network by market capitalization ($200B) with nearly $40B in value locked in decentralized finance (DeFi) projects, when it changes its block consensus mechanism from Proof-of-Work (PoW) to Proof-of-Stake (PoS).
A Defining Moment for Crypto
Virtual currencies like bitcoin and ether are built on widely agreed “consensus rules,” used to evaluate whether transactions on their respective blockchains are valid. Any proposed change, upgrade or fork to these consensus rules must be agreed to and implemented by all network stakeholders (developers, miners, validators, etc.) for the system to function. The Ethereum merge may be a defining moment for crypto as it could be the first time that a blockchain changes its consensus mechanism.
The CME CF Ether-Dollar reference rate (ETHUSD_RR), which underpins the suite of CME Ether and Micro Ether futures and options contracts, is calculated by taking executed spot market transactions, in the ETHUSD pair, from six constituent exchanges: Bitstamp, Coinbase, Gemini, itBit, Kraken and LMAX Digital, during a one-hour calculation window, 3:00 – 4:00 p.m. London Time. The ETHUSD_RR has been published daily, without fail since its inception in May 2018.
The calculation and publication of the ETHUSD_RR is expected as usual on merge day. A series of contingency rules under the index methodology states that if one or more relevant transactions occurs during the hour-long calculation window, then a reference rate shall be published for that day.
The suite of CME Group Ether futures and options are expected to trade throughout the transition. However, they will be subject to the standard daily price limits and circuit breakers, to help maintain an orderly market.
Reference Rate on the Day of the Merge
Some spot exchanges have advised market participants of potential interruptions on the day of the merge. Such exchanges note that new ether deposits and withdrawals may be briefly paused, as a precautionary measure. These planned “downtimes” will permit the platforms to verify a successful transition from PoW to PoS on the Ethereum Mainnet.
Given the slightly different approaches that spot exchanges may take during the merge, and in the event of slight pricing deviations between these exchanges, the index rules have contingencies for potentially erroneous data.
For each individual constituent exchange, the volume-weighted median trade price across all relevant transactions of that constituent exchange is calculated, and in case there is a deviation of more than 10% between one exchange and all others, then all the trade data from that venue is excluded from the calculation for that day. Therefore, should there be any unusual activity at any spot exchange, the daily reference rate shall be calculated in a reliable and representative manner.
As a last resort, should there be market-wide outages, the index administrator, CF Benchmarks (CFB), shall announce a Market Failure Event on its website. In this extreme case, the ETHUSD_RR on that day shall be given by the Reference Rate published for the previous calculation day.
Hard Fork Treatment
After the merge, “Ethereum” will refer to the PoS version of the blockchain, and the ETHUSD_RR shall define the value of ether on the PoS chain, or Eth2. If consensus isn’t achieved, stakeholders may propose a so-called “hard fork” or permanent spilt of the blockchain, resulting in two distinct chains: The“old” PoW chain and a new token currently being dubbed “ETHPOW”.
Under their hard fork rules, CF Benchmarks will evaluate any hard fork against a set of pre-defined criteria to determine whether it is significant. If the hard fork is deemed significant, CF Benchmarks will launch a new, but separate, index on the new token pair.
CME Group Ether futures and Micro Ether futures settle to the underlying ETHUSD_RR on the last Friday of the contract month. The settlement date for the September contract is Friday, September 30, suitably after the anticipated merge date.
In the event of a hard fork, standard Ether and Micro Ether futures shall continue to settle to the ETHUSD_RR corresponding to the original token pair (ETHUSD). For clarity, the ETHUSD_RR will track the price of ether on the new PoS blockchain and will not include price activity from the proposed ETHPOW coin.
Market Positioning Ahead of the Merge
As we approach the highly anticipated event, we are seeing investors positioning themselves for the merge. Ether futures and Micro Ether options trading has reached record levels:
- Micro Ether options average daily volume (ADV) in August was more than 5,260 contracts, up over 130% from July.
- Micro Ether options Open Interest reached a record of 124,814 contracts on August 30 while average daily OI in August reached a record of 75,959, up over 135% since July.
- Ether futures ADV reached a record 7,042 contracts in Q3, up +52% from Q3 2021
Ahead of the merge, CME Group announced plans to launch options on Ether futures on September 12, pending regulatory review. Ether options will offer institutional investors greater flexibility and added precision to manage their ether exposure ahead of market moving events.
There may be no more influential crypto event than the merge. With a benchmark reference rate designed to withstand any disruptions, and a clearly defined hard fork policy, futures market participants can be confident in navigating the change effectively.
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