The ethereum ‘merge’ and subsequent fork are underway after six years. The question for exchange-traded product (ETP) investors now is which side of the protocol civil war their assets will be invested on.

The merge of the ethereum blockchain with the proof-of-stake Beacon Chain, unveiled in 2020, is essentially a mid-flight “hot-swap” of the engine underlying the world’s second-largest crypto asset, according to the Ethereum Foundation.

If successful, it could ensure the asset’s scalability and crucially cut its emission to a hundredth of the level produced by its outgoing proof-of-work protocol.

However, its new environmentally friendly architecture is not without its critics. While the validation process of new blocks under PoS is less energy-intensive, proponents of the PoW hash model argue PoS is a move towards greater centralisation, given those who wish to take part in validating blocks – via staking – need to deposit around $60,000 worth of ethereum.

This has caused a rift in those using the ethereum network, with some willing to transition to PoS while some PoW miners refuse to take part in the merge. The result is the fork, set to occur today, whereby a new token will be minted – ethereumPoW – which will operate on the ethereum network but continue to be based on PoW hashing.

This split poses an awkward question for ETP issuers, which now must decide which side of the fork clients’ assets should fall.

ETC Group was the first mover on this front, recently announcing it would launch the ETC Group Physical EthereumPoW (ZETW) to track the performance of the new PoW token.

The firm said all holders of its ETC Group Physical Ethereum (ZETH) would automatically receive ZETW securities on a 1:1 unit basis into their brokerage accounts, with CEO and co-founder Bradley Duke stating “it is only right that investors in our products should receive the proceeds of this fork”.

CoinShares, meanwhile, are taking a more cautious approach, with the issuer stating it expects to share a portion of the new PoW token with investors in its existing ethereum ETP “to the extent possible”.

However, for the time-being it is wary of the potential for “significant price volatility” and “risks associated with the stability of the technology”.

In turn, CoinShares said: “As a result, the issuer will continue to monitor the situation for ETHW, with a focus on the timing, adoption and viability of the new protocol and underlying digital currency before finalising any approach to a distribution associated with a fork event.”  

Elsewhere, 21Shares is considering launching an ethereum staking ETP to offer yield opportunities following the merge.

Slow and steady ETFs 

ETF flows in Europe have proven resilient so far during this year’s volatility while UCITS mutual funds suffered their deepest outflows since 2008.

While wrapped products booked €56bn during the first seven months of the year, the legacy fund structure saw a €161bn exodus over the same period, according to Bloomberg Intelligence, likely owing to investors favouring the low-cost passive approach, transparency and intraday trading characteristics prevalent across ETFs.

This is a trend that appears to play out across periods of volatility, said Detlef Glow, head of Lipper EMEA research at Refinitiv, with flows into passive products remaining steady throughout the Global Financial Crisis and euro crisis.

The recent flows chime with a pattern seen over more than a decade – mutual fund assets surge when the going is good but ETF flows remain positive in risk-on and risk-off settings. ETFs may have welcomed half the amount of assets mutual funds have since the start of 2020, but at a tenth of the scale of mutual funds in Europe. This shows they are now punching above their weight.

US Treasury liquidity approaching COVID levels 

MSCI has warned US Treasury market liquidity could be worse than during peak COVID-19 volatility if the Federal Reserve does not slow the pace of its asset sell-off. 

The Fed announced a considerable asset purchasing programme during the onset of the pandemic to maintain smooth functioning of markets and improve liquidity conditions. 

While successful in these aims, the policymaker now plans to continue unwinding the assets it accrued and up its sales to $60bn per month. Since announcing this balance sheet reduction, US Treasury markets have eroded over the past 10 months, with investors facing higher transaction costs and hedge slippage, MSCI said. 

Bank of America rates strategist Ralph Axel warned declining liquidity and resiliency of the Treasury market could pose one of the greatest threats to financial stability today, potentially worse than the noughties housing bubble.

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