Unlike Merge, Ethereum’s Shanghai upgrade could bring Ether price volatility

The next big catalyst for the crypto market is Ethereum’s Shanghai upgrade planned for March which will open the withdrawal of more than 16.5 million ether (ETH) staked in the blockchain.

The impending upgrade comes months after the Ethereum blockchain underwent a technological overhaul, called Merge, switching to a proof-of-stake consensus mechanism from a proof-of-work setting.

Traders may recall that ether, the second largest cryptocurrency by market capitalization, did not see much volatility after the merger took place on September 15 and conclude that the upcoming upgrade will be a non-event.

However, such conclusions may prove inaccurate, according to OrBit Markets, an institutional liquidity provider in digital asset alternatives.

“However, this time may be different. Even if the merger was a purely technological shift with no direct economic impact, the Shanghai upgrade will change the supply and demand of ETH in both the short term and the long term, and therefore capable of having a significant impact on ETH price,” Yang Zhiming, co-founder of OrBit Market and former head of derivatives for Asia Pacific at Deutsche Bank, told CoinDesk.

The Merge, as the name suggests, combined Ethereum’s then proof-of-work blockchain with the proof-of-stake Beacon chain. While the central upgrade made Ethereum more environmentally friendly and set ether on the path to becoming a deflationary currency, there was no immediate impact on the supply-demand dynamics of the cryptocurrency.

Ether’s price fell 10% to $1,472 on the day of the merger, but volatility quickly faded, with prices trading in a narrow $1,300 to $1,400 range over the following four weeks. Ether’s 30-day realized volatility fell from an annualized 85% to nearly 60% in the four weeks following the merger, according to data obtained from Amberdata. Realized volatility is a backward-looking calculation that measures the degree of price turbulence observed over a specific period in the past.

The upcoming Shanghai upgrade could affect the balance of demand and supply in the ether market right away, keeping the cryptocurrency more volatile than it was in the weeks following the merger.

“Approximately $25 billion worth of ETH will become available for withdrawal and sale. With stake returns expected to drop after the upgrade, investors who previously staked may cancel their stakes and move to other assets that offer better returns. This will create huge selling pressure on ETH- the price,” Zhiming said.

While the entire stake balance of more than 16.5 million ETH cannot be withdrawn on the Shanghai upgrade day, the total stake rewards of more than two years, equivalent to around 1 million ETH, can be immediately withdrawn, according to Saxo Bank.

These ETHs can be liquidated in the market, creating price volatility, as Saxo Bank’s Mads Eberhardt wrote last month.

Also, Ether could become volatile in the days leading up to the event, as a sign that the market supports fears of post-upgrade turbulence.

OrBit Markets recently proposed an ether volatility swap to capitalize on an expected increase in volatility in March.

A volatility swap is a futures contract on the future realized volatility of an asset, which allows traders to bet on the degree of price movement rather than the direction of prices.

In traditional finance, swaps are primarily settled in cash, based on the difference between the predetermined fixed volatility level called the volatility strike and volatility realized/observed in the relevant period.

“You can enter a volatility swap in March (first fix March 1, last fix March 31), where you buy the swap with a volatility strike of 70% volatility [vols]limited to 170% and limited to 45%,” Zhiming said. “Your maximum gain is 100 vols, and your maximum loss is limited to 25 vols.

The volatility strike in this case is 70%. Whether the exchange turns into a profit or a loss depends on the degree of realized volatility in March, which will be known at the end of said month. OrBit’s volatility swap is denominated in Circle’s dollar-pegged stablecoin USDC. In other words, profit, loss and security are all denominated in USDC.

“Volatility swaps are a very common and popular product in stock and currency markets and widely used by hedge funds and asset managers,” Zhiming told CoinDesk.

11:27 UTC: Adds OrBit’s spokesperson’s name.