Deflationary Ether Is Underperforming Bitcoin, Here Are 3 Reasons Why

While bitcoin has gained nearly 43% this month, ether has appreciated by 36%.

AccessTimeIconJan 30, 2023 at 11:10 a.m. UTC
Updated Jan 31, 2023 at 11:12 a.m. UTC

Ether (ETH) turned deflationary two weeks ago, with its net supply increase turning negative for the first time in over a month.

The second-largest cryptocurrency's net issuance or the annualized inflation rate dropped below zero on Jan. 15 and stood at -0.01% at press time, according to The data shows the leading smart-contract blockchain is now burning more ether than what's being minted as opposed to bitcoin.

Still, the native token of Ethereum's blockchain lags behind bitcoin (BTC) as January draws to a close.

While bitcoin has gained nearly 43% this month, ether has appreciated by 36%, CoinDesk data shows. The ether-bitcoin ratio, or ETH/BTC, is on track to post its second straight monthly decline.

Here are three factors responsible for ether's underperformance:

Defensive positioning before Shanghai upgrade

"The most important [reason] is defensive positioning ahead of the Shanghai update. In a few months, this will enable withdrawals of ETH from the Beacon Chain. Some fear a share of these unlocked ETHs will get sold," Ilan Solot, co-head of digital assets at financial firm Marex Solutions, said in an email.

Ethereum's Shanghai upgrade, expected in March, will allow the withdrawals of 17.2 million ether staked or deposited in Beacon Chain since December 2020.

The whole staking balance of 17.26 million cannot be withdrawn on the day of the upgrade, and only 43,200 ETH can be unstaked per day. However, the total staking reward of the past two years, which equates to around 1 million ETH, can be withdrawn instantly.

The market is worried that the unlocked ether will be instantly liquidated into the market, pushing the price of the cryptocurrency lower.

"The 1 million instantly withdrawable ether is more of a concern. This amounts to around 1% of free-floating ether, in other words, not staked ether. In a matter of minutes, the whole stack gets withdrawable, potentially causing holders to rush to exchanges to liquidate the ether as soon as the floodgates are open, pushing down the price," Saxo Bank said in a blog post.

"This sentiment about upcoming selling pressure is likely to be more powerful as the Shanghai hard fork comes closer," Saxo Bank noted, adding some traders may hedge against an expected price drop by shorting the cryptocurrency in the futures market.

Macro-driven bull revival

Favorable macroeconomic developments have partly fueled the recent crypto market rebound, helping bitcoin, a macro asset, outshine ether.

Recent U.S. government reports and business surveys have shown a decline in manufacturing activity and inflation expectations, bolstering hopes for an early end to Federal Reserve's liquidity tightening that roiled risky assets last year. As of Friday, traders saw a 55% probability that the central bank would pause rate hikes in May, according to the CME's Fed Watch tool.

"I think it's [BTC's bigger gains] because this move is based on changing macro regime towards the end of Fed hike cycle, so it's a pure monetary policy play (hence gold also performing) – that in itself to me is reflective that this move is being driven by institutions, not retail," David Brickell, director of institutional sales at crypto liquidity network Paradigm, told CoinDesk.

Singapore-based crypto options trading firm QCP Capital made a similar observation, saying, "All of the BTC gains this year have come during U.S. (trading) hours, with a sharp increase in open interest in CME futures."

Several institutions and companies like software vendor MicroStrategy have been looking at bitcoin as a hedge against fiscal and monetary policy imprudence since the crash of 2020. Ether, meanwhile, remains a bet on a wider alternative cryptocurrency ecosystem.

According to Adam Farthing, chief risk officer for Japan at crypto trading firm B2C2, bitcoin's relatively bigger gains stem from a short squeeze – a rally driven by the mass closure of bearish bets.

"In Q4 2022, the market held short BTC against perceived credit risk issues, which is now being unwound. The market did not hold this short in ETH, so there is no unwind," Farthing said.

Short interest in bitcoin rose after Sam Bankman Fried's crypto exchange FTX went bust in early November, raising the risk of a market-wide contagion. The CME futures traded at a record discount in mid-November, reflecting extreme bearish sentiment.

Bitcoin a gateway to crypto

The previous crypto market upswings began with bitcoin leading the way higher and alternative cryptocurrencies, including ether, outperforming the market leader in the later stages of the bull run.

History seems to be repeating itself, with bitcoin and stablecoins still being preferred as a gateway to the crypto market.

"For most macro investors, BTC is the obvious on-ramp into the crypto market – the most liquid, the widest range of on-ramps. We see this in the strong increase in BTC spot volumes (while ETH spot volumes have not risen much), surge in the open interest on CME and stronger positioning in the options market," Noelle Acheson, author of the popular "Crypto Is Macro Now" newsletter, said.

Lastly, rotation of money into more risky corners of the crypto market like gaming and non-fungible tokens (NFTs) seems to have played a role in slowing ether's ascent relative to bitcoin.

"One of our theories as of the moment is that speculative demand has rotated from ETH (blue chip) to riskier and newer coins such as APT and SOL. This has taken some of the buying pressure away from ETH despite it becoming deflationary," Matthew Dibb, chief investment officer at Astronaut Capital, said.

Gaming tokens like AXS and MANA have gained 80% and 110% this month, while APT and SOL have rallied 420% and 140%, respectively, according to CoinDesk data. Some ether holders may have rotated money into tokens associated with liquid staking services like Lido Finance and Rocket Pool, which are expected to see a surge in activity after the Shanghai upgrade.


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Omkar Godbole

Omkar Godbole is a Co-Managing Editor on CoinDesk's Markets team.