09 Aug 2022

ETHPoW and ETH2: The story of miners vs. social consensus and trading opportunities

Not everyone welcomes the Merge, and ETHPoW—representing the token for the PoW chain that might continue to exist— is getting increasing attention. This has led to the emergence of new trading strategies and all-time low ETH futures prices vs. spot.
Source: Skew
Background - ETHPoW and ETH2: The story of miners vs. social consensus
Last week we gave a brief on the Merge: the switch from Proof-of-work (PoW) to Proof-of-stake (PoS) consensus on the Ethereum blockchain. However, not everyone welcomes the switch, and ETHPoW—representing the token for the PoW chain that might continue to exist— is getting increasing attention.On July 27th, Chinese Ethereum miner Chandler Guo launched a campaign to hard fork the Ethereum blockchain. In the beginning, both chains would be identical, duplicating any holdings. However, although the network can be technically duplicated, the value cannot. There will be 2 USDC/USDT for 1 USD held by Circle/Tether. Stablecoin issuers will have to choose which chain stores the actual value, so in theory, they could decide which chain becomes the new Ethereum. However, doing anything against social consensus would be bad for business, and the Ethereum community has decided to switch to PoS. If stablecoins are worthless on the PoW chain, DeFi on PoW crumbles. But some exchanges will list ETHPoW, causing speculation on the asset and a race to extract as much ETHPoW from the dead ecosystem as possible. TL;DR: the trade is already becoming crowded (further expanded on below).There is no community behind ETHPoW, and interestingly, the list of ETHPoW supporters consists of either mining pools or exchanges. Ethereum mining is bigger than bitcoin mining based on revenue, so miners clearly have financial incentives to support an ETHPoW chain.
Source: Coinmetrics
However, no dApps or infrastructure providers have publicly supported the fork. And if everyone plans to sell ETHPoW after the Merge, it is yet to be known where the bids will come from.
New trading strategies emerges as Ethereum approaches merge
Instruments for trading the upcoming Ethereum merge and potential proof of work chain split are getting launched as trading strategies amid possible arbitrage opportunities emerge. In a series of threads, Galois Capital has made a case for trading a potential chain split in Ethereum following the Ethereum merge, and now a movement initiated by Guo for Ethereum PoW has gained traction.Galois is trading the merge, and a potential chain split through a delta neutral strategy, holding spot and shorting quarterly futures at equal size. Since announcing its trade, a discount to the spot market has emerged in quarterly ETH futures as illustrated further down in this article. This trade enables exposure to a potential chain split and is based on the assumption that ETHPoW will accrue a share of the current value of ETH. Both Poloniex and BitMEX have launched instruments to trade ETHPoW, with Poloniex launching an instrument for trading PoS ETH (ETHS) simultaneous to launching the ETHW alternative. ETHW at Poloniex currently trades at 0.06 ETH while ETHS trade at a substantial discount to stETH, albeit at low volumes. Nevertheless, a well of arbitrage opportunities seems to be erupting for traders as the situation develops.
Source: Tradingview (FTX), Poloniex
A ETHPoW alternative following a potential chain split will meet several challenges, in particular related to Ethereum’s “Ice Age Difficulty Bomb”, which will slow down the block discovery rate by increasing the complexity of PoW calculations. The potential ETHW split will likely have to hard fork its client and permanently remove the ice age feature to be viable in the long run.The case in favor of ETHPoW versus the already established Ethereum proof of work alternative Ethereum Classic, a fork that occurred following Ethereum’s infamous DAO hack in 2016, is that ETHPOW will launch with more infrastructure and contracts on chain than ETC. Nevertheless, ETHPoW will likely suffer from lacking support from stablecoin issuers such as Circle and Tether, in addition to WBTC as mentioned above. This could create a dicey environment in the ETHPoW DeFi ecosystem in the event of a launch. BitMEX Research has proposed a different strategy to take advantage of a potential split based on stablecoin exposure featuring a more complex execution.
Ether futures prices at all-time lows relative to Ether spot
While bitcoin futures trade at a premium to the spot market, Ether futures have started trading at all-time lows relative to the spot market, likely caused by the upcoming merge and a potential chain split on the horizon.
Source: Skew
Ether futures are trading at all-time lows relative to the spot market. Binance saw a massive 5% discount on average on Monday, a clear all-time low for the Binance ETH futures. The Ether futures discount is far from isolated to Binance. FTX’s discount is also at an all-time low, pushing below the discounts seen in the aftermath of the stETH crash following Celsius and 3AC’s implosions. CME is trading at a more conservative discount but also sees its futures trading below spot for the first time since its launch in February 2021. Overall, Ether futures have traded at low premiums throughout the summer, but nowhere near the current low levels. The discounts are accompanied by a rise in open interest, currently sitting near all-time highs. The discounts are likely a result of trading strategies ahead of the long-awaited Ethereum transition to PoS, related to Galois trade, shorting quarterlies, and longing spot through delta neutral exposure. The market is bracing for the possibility of a hard fork leading to the birth of a PoS ETH alternative and a PoW ETH alternative, as explained above.This is likely the key catalyst behind the futures discount. Interestingly, we saw similar dynamics unfold back in August 2017 ahead of the Bitcoin Cash fork, with BTC futures trading at an annualized basis of -9% on Okcoin. As the fork occurred, the basis again normalized. Similar effects might come into fruition as we approach the Ethereum merge.
Open interest in Ethereum near all-time highs in notional terms
Open interest in notional terms in Ether futures and perps nears new all-time highs as the Ethereum futures basis decline to all-time lows.
Source: Skew
The ETH denominated open interest in ETH futures and perps has climbed to near 4.2m ETH. This is the second highest ETH denominated open interest recorded ever, only beaten by the 4.21m highs of July 14th this year. The open interest peak in July was caused by massive hedging, likely motivated by the promising arbitrage opportunity related to Celsius’ bankruptcy and corresponding large holdings of stETH trading at a large discount to ETH. The current peak, however, is likely caused by the delta neutral trading strategy explained above.While ballooning open interest amid extreme discounts in futures may foreshadow a short squeeze, a majority of the recent surge in leverage is likely caused by more conservative risk management, affiliated with low leverage and delta-neutral exposure. Thus, the likelihood of a sizeable short squeeze in ETH is less potent in the current market climate.
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