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The perpetual futures market serves as the battleground for institutions, risk-hedgers and speculators alike. In the bull run of 2021, perpetual futures acted as one of the main catalysts for all time highs as new money piled into the market with excessive leverage. Flash forward to September 2022 and we’re seeing this new money return to perpetual futures markets more ferociously than ever, specifically for ETH, with open interest recently breaking all time highs, ahead of one of the biggest idiosyncratic catalysts crypto has seen in some time, the Ethereum Merge.
In this article I will break down the nature of the positions in derivative markets being taken up ahead of the Merge, what that means for the price of ETH in both the short and long term, and I’ll take a data-driven look at whether spot or futures markets are the main force behind ETH’s price right now.
All eyes on ETH
As the Ethereum network approaches a defining moment in its brief history, investors in ETH are understandably anxious and excited in equal measures. The Merge has been likened to ‘replacing a plane’s engine mid-flight’ by skeptics, while the bulls hail the transition as the game-changer for the adoption of Ethereum. This divide in opinion paves the way for increased volumes in ETH perpetual futures markets as investors on either side of the debate look to position themselves accordingly ahead of the Merge.
We’ve seen this play out in the share of perpetual futures volume between BTC and ETH, with ETH commanding 45% of volume at the start of the month to 57% at the end of August as the Merge approaches.
New money floods in
I mentioned that money was coming into futures markets more ferociously than ever as we approach the Merge. Open interest is a measure of how many positions in futures are open at that time and represents the amount of capital currently invested in futures. In my view, it's important to look at open interest in the asset’s native units, i.e denominated in ETH, as when taking open interest denominated in USD you have price effects baked in. As we can see below, open interest in USD closely tracks the price and usually struggles to show the flows of capital in the futures market.
What we don’t see here with the USD metric is the massive amount of new positions entered into in the last month or two as the Merge approaches. Open interest denominated in ETH shows us that the number of futures positions open at this time represents a staggering all-time high, acting as a massive leveraging force on the price action of ETH over the next few weeks.
Funding Rates
Funding rates bring perpetual futures contracts closer to the index they track. If there is more demand for long futures contracts, the funding rate will be positive and those taking long positions pay shorts in order to incentivize a balance between positions. Often however, sentiment is so imbalanced that the funding rate can persist, either positive or negative. Since the bull run of 2021 the funding rate has been persistently hovering below neutral as negative sentiment seeped into the futures market.
Interestingly, with regards to ETH, as we approach the Merge funding rates have dipped sharply negative to close out August. This dip negative, coinciding with a buildup in open interest, leads us to conclude that the majority of the new money piling into futures markets for ETH are short-biased.
There are a couple of reasons investors could be going short ETH futures ahead of the Merge:
The first of which is simply naked short positions against ETH, betting on an unsuccessful or delayed transition to proof-of-stake. Based on the fact that the previous Merge dates were pushed back several times, this might not be a bad bet, but it's looking more and more likely by the day that the Merge goes ahead successfully, particularly after all testnets transitioned without a hitch. I find it hard to believe that investors would be naked short ETH ahead of such a potentially catalytic event.
The second reason, and far more likely in my opinion, is that this is a case of investors hedging their long spot ETH positions ahead of the Merge. Hedging long ETH positions allows investors to take some risk off the table ahead of an event that could, in theory, go pear-shaped. A strategy also doing the rounds involving short ETH futures has been to go long spot ETH, short futures and leave yourself eligible for any ETHPOW (ETH proof of work) airdrop. Think of this as a dividend strategy, eliminating any price risk by going long spot, short futures, but collecting a potential dividend in ETHPOW.
If the Merge is successful, and a proof-of-work chain fails to take off, we should see a lot of these short ETH positions being closed out. When the majority of an asset's daily trade volume is in the futures market, which we’ll see later, closing out shorts should be positive news for the price of that asset. When you combine these closed out shorts with a removal of c.$40m of daily miner selling as a result of a move to proof of stake, you could have a rather rosy outlook for ETH in both the short and long term as two forces of massive selling pressure are lifted. As we can see below, negative funding rates stemming from short positions have accompanied ETH’s fall from the $2,000 level and moved in tandem with the price. A move towards positive territory for ETH funding rates could be on the horizon if these shorts are to be closed out post-Merge, which will certainly help price sentiment.
Spot vs. Perpetual Futures Volume
We’ve seen negative funding rates and a buildup of open interest coincide with ETH falling over 30% from its highs this month. This begs the question, how much influence does the perpetual futures market have over crypto prices? This is a question of price discovery, and really boils down to which market leads price discovery at the moment, spot or perpetual futures? One way this is to look at volumes - volumes typically correlate to price movements and if futures markets are seeing a greater increase in volumes than spot markets we might determine that the futures market is leading price discovery.
Looking at ETH perpetual future daily volume over the last year, we can see a large increase from $19bn to over $33bn. Meanwhile daily spot volumes rose from $3.7bn to $4.8bn in just over a year.
Breaking those volumes down into a ratio to assess the moves against each other, we can see the rising dominance of perpetual futures volume for ETH as the ratio of perps to spot volume has increased from 5 times the volumes to roughly 7.
An increasing amount of perpetual futures trades are being made relative to spot markets and they are beginning to have an outsized influence on sentiment surrounding ETH. Back when markets were at all time highs last November, perps only did 4x the volumes of spot markets. Now at 7x the volumes and with open interest at all-time highs, it seems investors and institutions are turning to perpetual futures to place their bets on ETH, which as we’ve seen over the last month have been predominantly biased to the short side.
Options
The same trend we’ve seen in perpetual futures of short positions in ETH, or risk hedging ahead of the Merge, is mirrored in the options market. Put buyers [Put = option to sell an asset at an agreed upon price, generally seen as a bearish bet] look to lock in price levels below which their losses are stopped. This is clear when looking at the volumes between the 1k-2k strike levels for ETH options that expire pre-Merge, as the 3 top volume strikes are 1600, 1500 and 1400, with puts dominating for the latter two strikes.
1700 was the first strike price we observed where call volumes overtook puts, indicating this is the level where options investors become less worried about negative price risk and are looking instead to partake in any upside with call options.
When people think of crypto options they think of speculative long positions, but the volumes in pre-Merge options could arguably be the most obvious case of risk hedging that crypto options markets have seen. The put/call volume ratio is virtually split down the middle for options expiring pre-Merge, which is a rarity for crypto options. Post-Merge however, the split reverts to 73% in favour of call options as speculative investors dominate, betting on a successful Merge.
The options market for ETH is perhaps the best insight into the sentiment of investors two weeks before the Merge. Simply put, nervous in the buildup to the event, hedging risk and limited in their speculation. Looking past the Merge, investors seem to be hesitant to place short bets as the potential for positive price action in the short term is high with the removal of the aforementioned selling pressures.
Conclusion
With a rising dominance of perpetual futures volume versus spot markets, derivatives markets are having outsized effects on price action at present. None more so than ETH, which is facing a monumental, volatility-inducing event in the Merge in a couple of weeks time - and futures markets are tailor-made for high volatility events. Investors seem bullish on the long-term future of Ethereum, as evidenced by the options markets, but in the short term remain anxious at the possibility of a self-inflicted crisis. Either way, the Merge is one of the only events in crypto as of late that hasn’t been macro driven and it will be interesting to see if it sparks a breakout towards a lower correlation with the stock market, for better or for worse.
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