With a little over two weeks to the Ethereum Merge, and ETH rallying over 100% since the June lows — many wonder, is the ETH Merge already priced in? Find out below.
You might have noticed that there's something important happening on the Ethereum network. Like, this thing called the Merge, we may have published one or two articles about:
- This one, where we covered everything you need to know about the Ethereum Merge.
- Or this one, where we debunked misconceptions about the Merge.
- Here, we covered the ETH Merge Trade.
- We also looked at the differences between Ethereum proof-of-stake and proof-of-work.
So, what else could we possibly cover?
Well, the Merge is less than one month away and ETH is down 15% over the last seven days, after a spectacular run of over 100% since June lows:
Let's talk about whether the Merge is priced in at this point.
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How to Value the Ethereum Network
“Intelligent individuals learn from everything and everyone; average people, from their experiences. The stupid already have all the answers.” — Socrates.
If someone's telling you they know the value of ETH post-Merge, recall the quote above.
However, we can estimate the value by listening to smart people like Arthur Hayes. His essay "Max Bidding" lays out his investment thesis for ETH. To make a very long essay very short, Arthur argues that ETH staking allows us to value the crypto coin as a bond using a discounted cash flow (DCF) model, as referenced in his piece: Five Ducking Digits.
In other words, we can apply traditional stock valuation methods to post-Merge Ethereum. Cutting the math wizardry short, he arrives at the following probability matrix:
The four scenarios are:
- Successful Merge and money printer switched on (Base scenario)
- Successful Merge and money printer switched off (Scenario 1)
- Unsuccessful Merge and money printer switched off (Scenario 2)
- Unsuccessful Merge and money printer switched on (Scenario 3)
Arthur arrived at the different prices (partially) by applying a valuation and partially, well, by plugging in random numbers. Equally, the probabilities are his own estimations. Thus, he arrives at an expected fair ETH value of $2,815 on March 31, 2023.
You can replicate his valuation method by doing the following:
1. Assign probabilities to the four events above (ask someone competent if you feel clueless)
2. Assign realistic price targets for the four events on the target date (March 31, 2023).
3. Multiply a scenario's price with its assigned probability, add all of them together and divide by four.
Depending on whether you are more bullish or bearish than Arthur Hayes, you might end up with a different price target.
What Traders Are Betting On
Ok, so Hayes is turbo-bullish (he doubled down in his latest essay "ETH-flexive"). What about the market, though?
A good way to gauge market sentiment is to look at options expiries and futures rates. A refresher:
- Options allow you to bet on the future price of an asset with the choice to buy or sell the underlying. You do that by buying an option for this asset at a designated future date for a specific price.
- Futures do the same but the holder is obligated to buy the underlying asset. Roughly speaking, futures allow you to take a leveraged position more easily.
For a more detailed breakdown, read: Crypto Options vs Crypto Futures — What's the Difference?
Looking at ETH options expiries, we see the following, courtesy of Glassnode:
Open interest in options markets is near all-time highs and higher than for Bitcoin. This means traders are particularly interested in betting on ETH prices in September.
And which prices exactly?
Options traders are extremely bullish, with a lot of open interest congregating around very high strike prices like $4,000 and $5,000. The maximum number of options expiring out of the money would be at the strike price $1,350, which is currently below the spot price.
Going a bit further into the future, traders are not expecting much volatility in October after the Merge:
The flat curve basically means options traders expect sideways action.
Let's look at the spot market. Spot demand is quite low at $700M. Open interest in options is $6.6B. Translation: traders are betting on higher prices but don't want "physical" ETH.
Another indicator is the futures market. Traders there are mostly short because the funding rate is negative. That means short positions pay long positions, so most traders must be short. Why? Because traders hedge their bullish options/spot ETH bets with bearish futures bets.
Read: What Are Funding Rates and What Do They Do?
Don't ask about the financial wizardry details behind how it works, but here's the proof:
Put simply, this chart shows the short-term (three months) futures funding rates reaching -3.68% annualized — indicating that traders are willing to pay a premium for downside protection.
Ok, so is the Merge now priced in or not?
Let's find out.
Merge Variables To Watch
One important factor is a possible Merge delay. In light of the Tornado Cash situation, voices in the ETH community have become vocal about reconsidering the implications of going ahead with the Merge right away:
This is what some call "OFAC risk" i.e., the risk of ETH transactions being censored.
Is it real?
Yes.
Will the Merge be delayed because of it?
Seems unlikely.
A last-ditch effort to delay the Merge could do more harm than good. Centralization risks did not appear yesterday. The Ethereum Foundation must have been aware that these exist when it designed the network. A delay seems unlikely.
Is PoW Ethereum a Danger?
Not really. We covered it in our Ethereum PoW vs PoS article. Many in the space believe that the potential fork is mostly a distraction.
However, staking yield is the important variable to watch. Staking yield is influenced by two factors:
- How much ETH is staked: more ETH staked means lower yield.
- How high is the demand for ETH blockspace: more demand means more ETH burned due to fees and higher yield.
As a staker, you'd ideally want high demand for blockspace (high fees) and few people staking.
However, because non-stakers implicitly pay stakers, the game theory suggests staking is the optimal strategy. Why would you forgo a yield if you plan to hold ETH?
Blockspace demand is influenced by several factors: the market situation, the Ethereum ecosystem developing and L2 solutions. Paradoxically, as a staker, you do not want transactions to go to L2s. Better if gas fees are high and more ETH gets burned.
This dynamic has led to wildly varying estimates of what real staking yield will be after the Merge. While some say 7-14%, others suggest those yields will quickly collapse to 2.5% in 2023.
But the staking yield matters for valuing the Ethereum network.
Put simply: if you're an institutional investor with a $100M bazooka to deploy, the difference between 3% and 12% yield is massive when applying a DCF model.
Okay, but is the Merge priced in or not, just tell me already!
Well, it depends.
It depends on the staking yield and the proportion of ETH staked after the Merge. Here's a DCF model to plug in your own numbers.
The Bottom Line
While it may seem like an inconclusive answer — that's what participating in the markets, be it crypto or equities, is like.
The best TL;DR version: from the options and futures market, it seems that traders are buying the rumor and selling the news. They're betting on rising prices in the final weeks before the Merge. What will happen in the long run remains to be seen.
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