If you have been following the crypto market for some time, you probably have heard that Ethereum, the world's largest smart-contract blockchain, could <a href="https://www.coindesk.com/tech/2022/08/24/ethereum-proof-of-work-forks-gift-or-grift/">undergo a hard fork</a> later this month, splitting into a <a href="https://www.coindesk.com/learn/2020/12/30/what-is-proof-of-stake/" target="_blank">proof-of-stake</a> (PoS) chain and a <a href="https://www.coindesk.com/learn/2020/12/16/what-is-proof-of-work/" target="_blank">proof-of-work</a> (PoW) chain.
The Ethereum chain with the PoS consensus mechanism will retain the seven-year-old ether (ETH), currently trading at $1,570, as its native token. The PoW chain, representing a group of miners opposing the impending <a href="https://www.coindesk.com/learn/what-is-the-merge-and-why-has-it-taken-so-long/" target="_blank">Merge</a>, or switch to PoS, would have a new token called ETHPOW.
We know that if the chain splits, ETH holders will receive ETHPOW free of cost, much as corporate shareholders receive additional units on a stock split. What's not known is the value of the ETHPOW token.
One way to gauge the potential value is to look at the difference between spot ether and futures prices, according to Paradigm, which focuses on over-the-counter trading for institutions.
As of Wednesday, ether Sept. 30 expiry contracts listed on major exchanges traded at a discount of $18 to the spot price, indicating the market is expecting the ETHPOW token to draw a price of at least $18 at inception.
"We can infer how much the market estimates ETHPOW will be worth from simply looking at spot-future basis, since spot = PoS + PoW, while future is just PoS," Paradigm said in a Merge-focused blog post <a href="https://www.paradigm.co/blog/ethereum-merge-crypto-derivatives?utm_campaign=q3_22_eth_merge&utm_source=twitter&utm_medium=social">published</a> Wednesday. "Currently, the basis is implying ETHPOW to be priced ~$18, which is ~1.5% of ETH market cap."
Trading giant Cumberland <a href="https://twitter.com/cumberlandsays/status/1562069899417108480?s=21&t=81jVWuKJCs6wEVP-fJpKH">voiced</a> a similar opinion last month, saying, "we can infer how much the market estimates ETHPOW will be worth from the spot-future basis."
The logic behind considering the negative $18 basis as a possible ETHPOW price is that the discount represents the risk-free cost of collecting the potential forked tokens. So, if traders are willing to pay $18, they must expect the token to be priced at $18 or higher.
Dissecting the risk-free trade
Traders stand to receive ETHPOW free of cost if they hold ETH and will receive nothing if they take bullish exposure through the futures or options market. So, ether's price can be taken to represent the value for ether as well as potential ETHPOW token.
However, holding ETH to earn ETHPOW means being exposed to ETH's price volatility. A decline in ETH's price would eat into money made from receiving ETHPOW for free and liquidating in the spot market.
So, the ideal strategy to make risk-free money is to buy ETH and short September futures – the so-called spread trade. That way, ETH holders can pocket ETHPOW without any directional risk. Assume a trader took the trade on Wednesday, when futures were priced at an $18 discount. The discount is essentially the cost of collecting ETHPOW tokens risk-free because futures sold at a discount of $18 would eventually converge with the spot price.
Paradigm <a href="https://www.paradigm.co/blog/ethereum-merge-crypto-derivatives?utm_campaign=q3_22_eth_merge&utm_source=twitter&utm_medium=social">said</a>:
The futures premium/discount narrows as expiry nears and eventually converges on the spot price on the day of the settlement.
The hedged long spot trade aimed at collecting ETHPOW without directional risks is one of the most popular ways of trading the impending Merge.
"With our newest integration with FTX, the spot/30 Sep future spread price of around $18 can be seen as a derivative market of how much traders are willing to pay to be long spot/short futures to receive ETHPOW tokens," Paradigm's Patrick Chu told CoinDesk. "We have seen a large uptick in clients since the start of the partnership."
Last month, Paradigm, in partnership with crypto exchange FTX, launched single-click execution of the spread trades.
The value for ETHPOW tokens suggested by futures basis is significantly lower than the price at which <a href="https://coinmarketcap.com/alexandria/glossary/what-is-an-iou" target="_blank">IOUs</a> representing the token are currently trading on exchanges MEXC, CoinW, Phemex, Bitrue, and Gate.io. At press time, the ETHPOW IOUs traded at $50, according to CoinMarketCap data. Prices reached as high as $140 early last month, indicating frenzy around the potential hard fork token.
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