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EthereumBitcoin

Will "The Merge" be a genuine catalyst for Ethereum?

Chris Weston
Head of Research
Sep 13, 2022

Rising as a talking point in social media and among Pepperstone’s crypto trading clients is ‘The Merge’ – a union between Ethereum and Beacon Chain, that takes place on Thursday (Google has a countdown clock).

Essentially, this long-awaited move, sees ETH move from “proof of work” to “proof of stake” system – the two systems are vastly different in their approach, but at their heart sits a belief that this change will provide the more effective platform for innovation, scale and greater adoption, largely due to the far lower carbon footprint.

If the Ethereum project is to grow and WEB3 evolves longer-term most believe ETH truly needs the “proof of stake” platform – innovation will take this further, but to attract real institutional capital, it needs to pass the ethical filter.

What will The Merge mean for traders?

An interesting debate has surfaced – that being whether the confirmation of ‘The Merge’ compels crypto traders to push price above the August highs of $2k and potentially into a bull trend. While others float the idea of a ‘buy the rumour, sell the fact scenario’ playing out.

The evidence for me says neither are that likely and ETH will move in alignment with market forces – sentiment, liquidity, and flow. 

Firstly, if we look at the ETH/BTC ratio, we did see outperformance from ETH in mid-July and we could argue ETH priced some degree of goodwill towards “The Merge”. However, in these weeks leading into "The Merge", there has been no real preference in the choice of crypto as a trading vehicle. We see a similar feel in the US500/ETH ratio, where the two instruments have held a tight correlation for weeks.

One could argue that if there is to be a “buy the rumour, sell the fact” it will be modest at best.

Overlapping ETH to reserve liabilities (these are liabilities on the Federal Reserve’s balance sheet) we can see a tight relationship for over a year – so while we live in the future as traders, crypto and equity markets are following reserves which are released once a week.

The assumption we make is that if this relationship holds then we could easily argue that ETH faces a strong downside – why? Well, as the Fed increases its balance sheet reduction plans by not reinvesting $95b of maturing Treasuries and mortgages each month, we must see its liabilities fall – it feels that reserves are the most likely to fall.

For more reading on reserves, the St Louis Fed website is a wealth of information - https://www.stlouisfed.org/financial-crisis/data/reserve-balances-with-federal-reserve-banks

Rightly or wrongly, the market sees reserves as liquidity – if reserves fall, they sell risky assets. The opposite was true throughout 2020/21 when the Fed bought $4.5t of bonds, and the market saw crypto as a clear beneficiary of this system liquidity. 

For now, it seems ‘The Merge’ benefits long-term ETH holders, as it is an important part of the journey – but it will not have an initial effect on lower transaction times and fees. Perhaps the biggest beneficiary will be the validators – the barrier to entry in this space already seems high, but under a "proof of stake", the stronger will get strong far faster. 

We watch the countdown to “the Merge” – it is seeming unlikely (in my opinion) but we can’t rule out a buy the rumour sell the fact playing out, which would see short ETH/long BTC working as a pairs trade. But while this is a key milestone for the long-term, from a short-term trading perspective it feels like the weight of evidence is that traders are far better off watching variables such as liquidity and sentiment over the switch to “proof of stake”.

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