Anomalous Ether Futures Pricing Condition Is Likely to Revert After the Merge

"The current state of backwardation reflects the general market view that ETH will fall following the Merge, but this could be short-lived," one observer said.

AccessTimeIconAug 24, 2022 at 12:25 p.m. UTC
Updated May 11, 2023 at 6:40 p.m. UTC
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Ether (ETH) proponents would like all price indicators to flash bullish signals as Ethereum's long-pending upgrade, dubbed "the Merge," nears.

The futures market, however, has slipped into backwardation, an abnormal condition in which futures trade below spot prices, indicating expectations the cryptocurrency will weaken in coming months.

At press time, one-month ether futures listed on major exchanges traded at an annualized discount of 8% to 10% while the three-month futures traded at a discount of around 5%, according to data tracked by analytics firm Skew.

The condition could be short-lived, some observers say, and futures will probably flip back to trading at a premium – a situation known as contango – after the upgrade. That's the usual market position, which reflects the time value of money. The merge, slated to happen in mid-September, will combine Ethereum's current proof-of-work (PoW) blockchain with the proof-of-stake (PoS) Beacon Chain that went live in December 2020. The change is likely to reduce supply of the cryptocurrency, providing an extra boost to the price.

"The current state of backwardation reflects the general market view that ETH will fall following the Merge, but this could be short-lived," Katie Talati, director of research at Arca, said. "We think ether's real price appreciation will happen after the Merge, driven by increasing ETH locked up staking/securing the chain."

Trading giant Cumberland says the Merge will remove $40 million worth of miner selling from the market and lead to a 90% drop in annual issuance. Furthermore, the annualized yield on staking, or locking, coins in the network is projected to double to at least 8% from the current 4%, a jump that's likely to fuel staking and suck a considerable amount of ether from the market. Staking yield is the return investors earn for locking coins in a network and is analogous to investing in bonds.

The switch to PoS will require validators to stake a minimum number of coins to validate transactions in return for rewards. Under PoW mechanisms, miners solve a computational problem to verify transactions and tend to liquidate the coins received as rewards to fund their operations.

Merge-focused trades

"We are experiencing backwardation as a result of investors buying ETH spot and shorting the ETH futures in order to collect the ETH PoW airdrop expected at the time of the merge, essentially isolating ETH price risk for the "free" dividend," Arca's Talati said.

Some Ethereum miners have pushed back against the blockchain's transition, proposing to split the main Ethereum chain and continue the current PoW chain post-Merge. If that occurs, ETH holders will shift to Ethereum's new PoS chain and also receive the forked ETH PoW tokens for free.

The chance of getting free tokens has prompted traders to initiate basis trades that involve buying ether in the spot market and selling or shorting futures contracts. That means they're positioned to collect any free tokens from a potential chain split while bypassing ether price risks.

"The futures market will likely go into contango as traders unwind shorts after the Merge," said Shiliang Tang, chief investment officer at digital asset investment firm LedgerPrime.

Cumberland said in a recently published report about the merge and the market structure, "This market anomaly [backwardation] will not persist for long, especially if the merge proves successful and stokes a broader rally."

Constant sellers?

Some observers say the Merge will bring constant sellers to the futures market. So while pricing may return to contango, premiums could remain depressed relative to bitcoin (BTC), all else being equal.

According to Cumberland, staked ether will remain locked until Ethereum Improvement Proposal (EIP)-4788 releases them. That date is not yet known. So, ether stakers, who are exposed to price declines, are likely to sell futures, keeping premiums in check. The popularity of staking depends on yields, and the greater the yield, the stronger the demand for ether staking and selling ether futures.

"Ether will have PoS yield attached to it after the Merge and stakers will be unable to unstake coins for months. Therefore, there will be demand to sell futures/forwards on ETH to hedge ETH," said Joshua Lim, head of derivatives at CoinDesk sister company Genesis Global Trading.


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Omkar Godbole

Omkar Godbole is a Co-Managing Editor on CoinDesk's Markets team.

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