Grayscale: Why is Ethereum performing poorly? What will happen in the future?

Source: Grayscale; Compiled by: Baishui, Golden Finance

Summary

• Crypto valuations fell in early August amid concerns about the outlook for the U.S. economy and broader financial market volatility. Ethereum underperformed, likely due to increased futures market positioning and selling by a few large holders.

• Grayscale Research expects token valuations to rebound if the U.S. economy continues on its path to a “soft landing.”

• However, even in a weaker economic environment, Grayscale Research has reason to believe that downside risk to prices may be more limited than in the past.

Crypto assets and broader financial markets stabilized midweek after a sharp drop from Friday, August 2 to Monday, August 5 (Figure 1). Although major token prices are generally less correlated with other asset classes, volatility in traditional markets may affect cryptocurrency valuations.

Figure 1: Bitcoin and Ethereum Fall in Early August

The immediate cause of the decline was the weaker-than-expected US July jobs report released on Friday, August 2. In particular, the report showed that the unemployment rate rose by the same amount as in previous recessions. [1] Fears of a cyclical recession led to weak performance in cyclical assets such as equities, while traditional safe haven assets such as US Treasuries, the Japanese yen, and the Swiss franc performed strongly (Figure 2). Non-US equities and strategies that short US equity volatility performed particularly poorly. Both Bitcoin and Ethereum fell; while Bitcoin performed relatively well on a risk-adjusted basis, Ethereum underperformed other cryptoassets and many traditional market segments, as we explore further below. Among major cryptoassets, Solana significantly outperformed the others.

Figure 2: Ethereum Underperformed

While Ethereum is more volatile than Bitcoin, its performance during the recent decline was more pronounced than usual. For example, Figure 3 shows the largest percentage declines in Bitcoin’s price since 2020 and compares them to the declines in Ethereum’s price over the same period. During these events, Ethereum’s price typically declined by about 1.2 times as much as Bitcoin’s price. The latest “crypto winter” (i.e., bear market period) showed similar relative performance. [2] By contrast, as of August 2024, Ethereum’s price has declined by about 1.8 times as much as Bitcoin’s price, suggesting that Ethereum faces additional, unique downward pressure.

Figure 3: On average, Ethereum's decline is usually 1.2 times that of Bitcoin

One of the reasons for the relatively large decline in Ethereum prices appears to be the excessive long positions in perpetual futures. In May 2024, traders significantly increased their total perpetual futures positions as the U.S. Securities and Exchange Commission (SEC) approved issuers’ 19b-4 applications for U.S. spot Ethereum exchange-traded products (ETPs) (Chart 4), perhaps anticipating further price increases following full regulatory approval; that approval was received in July 2024, and the U.S. spot Ethereum ETP began trading shortly thereafter. Subsequently, some long positions were liquidated during the recent decline, accelerating the price decline. On August 4, the price of Ethereum fell 7.6% in just three minutes, with total perpetual futures liquidations reaching $340 million on that day alone. [3] Because the sell-off occurred during the U.S. overnight trading session and Binance’s spot price was at a significant discount to Coinbase, [4] the liquidations appear to have been driven primarily by leveraged traders in Asia. [5]

Chart 4: Increased leverage in Ethereum futures in May 2024

Another factor that may have contributed to Ethereum’s underperformance is actual and expected selling by a small number of large holders, including market maker Jump Crypto, venture capitalist Paradigm, and Golem Network (a crypto protocol with a large ETH treasury asset). [6] While it is impossible to determine the exact amount of the sell-off, Grayscale Research estimates that these entities collectively held around $1.5 billion worth of Ethereum (based on Ethereum prices at the time) before they began moving tokens, based on data from analytics platform Arkham Intelligence[7]. The decline in the number of active validators and the rise in Ethereum’s staking reward rate also suggest a shift in the relatively sticky token supply, which could affect market sentiment. [8]

Broader financial markets have stabilized over the past week. Perhaps most notably, the VIX index, a measure of implied volatility in U.S. stocks, fell to 26% at the close of trading on Thursday after reaching an intraday high of more than 60% on Monday (Chart 5). Whether markets continue to stabilize will depend on upcoming macroeconomic and corporate earnings data, as well as any policy responses from the Federal Reserve or other central banks. On the economic data front, key upcoming reports include the weekly unemployment claims report (released every Thursday), the consumer price index report (to be released on August 14), and the next employment report (to be released on September 6). The Fed is likely to cut interest rates at its September 18 meeting, but the market is more focused on the path of policy after that. Policymakers may provide more guidance at the Jackson Hole Symposium on August 22-24.

Figure 5: Market volatility has declined over the past week

If the U.S. economy avoids a recession and continues on its path to a “soft landing,” Grayscale Research expects token valuations to rebound and Bitcoin to retest its all-time highs later this year. However, even in a weaker economic environment, Grayscale Research has reason to believe that downside risk to prices may be more limited than past declines. These include relatively stable net demand from new U.S.-listed ETPs, insufficient credit provided by centralized financial institutions during this cycle[9], and relatively subdued returns on altcoins since the beginning of the year. The changing political landscape in the U.S. surrounding the crypto industry may also reduce downside risk to valuations compared to past cycles.

Economic cycles are an inevitable feature of investing in almost all asset classes, and uncertainty about the macro outlook should be viewed as a short-term risk for crypto investors. Meanwhile, Grayscale Research believes that people have little tolerance for severe economic downturns and expect policymakers to start printing and spending money as soon as problems arise. Irregular practices in monetary and fiscal policy are one reason some investors choose to invest in Bitcoin; therefore, a period of economic weakness could strengthen the long-term investment thesis for Bitcoin.

References

[1] Economists often refer to this statistical regularity as “Sam’s Rule.”

[2] For example, during the peak to trough period of Bitcoin’s price in the last cycle, both Bitcoin and Ethereum fell by the same amount. During the “bear market” from March 2022 to October 2023, Ethereum fell 1.3 times as much as Bitcoin. Source: Artemis, Grayscale Research.

[3] Source: Trading View, Coinglass.

[4] Source: Coinglass

[5] On-chain liquidations may also be one of the reasons for the sharp drop in Ethereum prices. For example, lending platform Aave reported $239 million in liquidations on August 5. Source: Dune Analytics. Data as of August 8, 2024. For illustrative purposes only.

[6] Source: The Defiant, CoinDesk, Arkham Intelligence data.

[7] Specific dates are June 21, 2024 for Paradigm, July 8, 2024 for Golem, and July 24, 2024 for Jump.

[8] Source: validatorqueue.com.

[9] Several centralized lending companies have gone bankrupt in recent years. Source: Blockworks.