ETH Merge: Backwardation in the Forward Curve Coming — Mitchell Dong

We have been receiving many questions from investors about how we are positioning our market neutral portfolio around the Ethereum Merge. We believe that the market is not yet reflecting the post Merge staking economics. We have been putting on a series of market neutral trades to reflect our thesis around the forward curve for Ethereum, post merge. Here is our thinking.

This year, one of the most anticipated events in the entire digital asset space is slated to take place: the Ethereum Merge. Ethereum will transition from proof-of-work to proof-of-stake, fundamentally changing important aspects of the protocol, chiefly how consensus is agreed upon. One of the expected results of this transition is that the economics of the Ethereum protocol will change substantially.

Holders of ETH will be able to stake their ETH and earn a yield — value which was previously transferred to miners will now be transferred to the stakers. As a result, we believe that the futures curve for Ethereum should be backwardated (downward sloping), to reflect this dividend yield. Why hasn’t the futures curve repriced already? We propose a theory: the Merge has been spoken about for years, but had been faced with many, many delays along the way. This resulted in a boy-who-cried-wolf effect, essentially a loss of credibility in the timing of the Merge itself. Furthermore, the staking yield after the Merge is uncertain, and subject to market forces.

Now we are closer than ever, and market participants are starting to believe that “this time it’s real.” Estimates vary of the post-Merge staking yield, but 5% could be considered a conservative lower bound in the near-term. On the basis of no arbitrage, we expect the futures curve to reprice to more accurately reflect this expected staking yield. If it didn’t, one could simply buy ETH, stake it, and sell the futures contract at a level less than the staking yield of the ETH (to be precise, the cash rate minus the staking yield), resulting in a risk-free staking yield. The market has not yet priced this opportunity, and we at Pythagoras believe it to be a potentially lucrative trading opportunity.

Who are the market participants, and what determines the shape of the futures curve? On the long side, there are speculators who bet on the market rallying. On the short side, there are speculators betting on the price going down, along with arbitragers looking to hedge out the directional exposure of a long ETH position. In this current bear market, there is weak demand for speculation on the long side, and arbitragers are desperate to gain any market-neutral returns. Futures are the most ideal product to hedge a staked ETH position, since one can lock in a fixed rate. Compare this to a perpetual future, where the funding rate is floating and thus represents a source of risk. Arbitragers want certainty; futures provide them.

Cash-and-carry arbitrage bounds enforce the shape of the curve in relation to interest rates, staking yield, and cost of borrow. The fair value of the spot-to-futures spread should be the USD rate minus the ETH rate. Suppose the current USD interest rate is 3% now, and further suppose the fair value for the ETH interest rate is close to its staking yield. If we assume a 10% staking yield, the fair value for the 1y future should be 7% below spot. For as long as the futures backwardation is less than the ETH yield, there will be arbitragers looking to close that spread in line.

The second aspect of this opportunity revolves around stETH (staked ETH via Lido, a staking service). Recently, there has been much discussion and publicity surrounding stETH’s depeg from ETH parity. stETH will eventually be redeemable for ETH, but not yet — one must wait for at least the Shanghai fork, the first post-Merge fork planned for Ethereum. Arbitragers may wish to buy stETH and sell ETH against it, to lock in that spread. They can do this either via futures or by borrowing ETH and selling it in the market; this demand to short-sell ETH will further depress the futures price, either by arbitragers directly selling the futures, or other arbitragers enforcing the cash-and-carry boundaries between the futures curve and the spot lending market for ETH. We like the extra scenario optionality that this long-spot/short-futures positioning provides, and we hope to profit from stETH without having to take the extra risk of holding the stETH/ETH spread itself. Lastly, our positioning stands to benefit from any hypothetical ETH1/ETH-PoW residual value that may or may not arise.


Mitchell Dong is a solar power developer and cryptocurrency miner and trader. He has been developing solar, hydro, cogeneration power facilities for 40 years in the US, Africa and China. He has also been a trader of physical uranium and electric power for the US and Scandinavia. He runs a hedge fund that trades cryptocurrency on behalf of bitcoin miners in Asia and USA and is actively sourcing low cost power for bitcoin miners globally.



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