Even as spot markets remain range-bound and trading volumes subdued, crypto option markets have undergone significant microstructural shifts in Q2. ETH has seen a marked rise in systematic volatility supply, starkly contrasting with a comparatively languid demand for ETH optionality.

Two factors can be partially attributed to this surge in ETH volatility supply: Ethereum's transition to a proof-of-stake model and the implementation of the Shanghai Fork in April. The Shanghai Fork, by introducing withdrawal flexibility, has prompted a significant rise in staking activities aimed at yield harvesting with validators. Currently, staked ETH represents 16% of the total supply.  

The charts below underscore the dramatic ETH staking inflows observed in May, leading to a sharp escalation in the quantity of staked ETH and the number of validators. As a result, ETH is gaining traction as a yield asset, which may account for the increasing tendency among token holders to sell volatility against their staked positions. This trend is clearly reflected in the noticeable increase in ETH volatility supply observable on Paradigm.

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The ETH systematic selling community is prominently headlined by a large systematic overwriter who concluded 2022 with a bang by rolling 90k Mar 1800 calls into Jun 1800 calls, injecting about 125k net vega into a market starved of natural ETH upside buyers.  

Paradigm flows suggest dealers to be considerably long the June 1800 strike due to this overwrite, which induces  'spot down / vol down' price action as they adjust their long vega / gamma exposure towards this strike. 

This dynamic was prominently exhibited during Monday’s sell-off (5-Jun), induced by the Binance/SEC news. Despite a 4% decline in ETH spot prices and low absolute levels of implieds, ETH's longer-dated fixed strikes decreased (as seen in the chart below). We believe it wasn't coincidental for the ETH spot to bounce back right after touching the 1800 strike level, even as BTC continued its downward trend. Given that dealers hold a majority of the open interest for the June 1800 strike, and the lack of natural taker interest for ETH ATM volatility, we might observe a significant pinning at the 1800 level heading into the June expiry, unless an impactful catalyst shifts ETH away from this magnetic strike.

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The Mar / Jun roll, significant as it is, only begins to reveal the depth of ETH volatility supply that's affecting dealer balance sheets through calendar rolls and onscreen outright sales.

Following the significant Jun / Sep overwrite, the systematic seller unloaded ~40k vega clips in Feb and Mar via call calendar rolls (25-35k contracts). Post-Shanghai Fork, the quantities have significantly increased, led by a 63k Jun / Sep 2200 call calendar sale, plus additional Sep sold on screen, adding up to -200k net vega. The backend volatility pressure continued with blocks of 28.5k Sep / Dec 2300 call calendars (-45k vega) and 36.5k Jun 2000 / Mar 2300 call calendars (-175k vega), further hammering 6-9M vol amid a lack of absent natural demand.  

See additional large prints below. We observe that the Dec 3k calls were possibly purchased, in our opinion, as an upside hedge to alleviate the margin burden. Collateralizing these trades necessitates substantial margin requirements, prompting us to question if this strategy is indeed the most efficient for extracting additional yield from ETH, particularly during Q1's intense rally characterized by blistering spot up / vol up dynamics.

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The identity of this sizable systematic overwriter is still shrouded in mystery, but the simultaneous surge in the user's vega supply and the strong growth in ETH staking deposits catches our attention. This concurrent development underscores the evolving nature of ETH volatility selling, which seems to synchronize with ETH's emerging identity as a yield asset in a proof-of-stake landscape.  While it remains purely speculative given that these trades do not occur on Paradigm, there's a possibility that this significant overwriter could be a large validator node. We must caution that we're not suggesting a validator is improperly mixing client funds to sell calls without depositors' knowledge. Unscrupulous activities like these, though they've occurred in the past, aren't a foundation of our speculation here. Instead, we envision that this could be part of a clearly defined, consensual program offered by a validator. Such a program might be designed to provide depositors with an additional yield-generating avenue for their staked ETH. This could explain their influence over the ETH volatility supply/demand imbalance, which has significantly affected the compression of both ETH's implied and realized volatilities described below.

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The challenges in warehousing this vega risk triggered a noticeable compression of ETH implied volatilities in absolute terms and relative to BTC, especially evident in 3-6M buckets where the overwriter's flow is focused.  Of course the ETH-BTC realized vol spread also trending lower is a big part of this spread compression.  However, the realized vol compression is directly a result of the significant ETH vol supply/demand imbalance spearheaded by this prominent overwriter.

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Irrespective of their origin, the latest ETH overwrite rolls have emerged as significant determinants of the asset's volatility dynamics. This trend is underpinned by the existing dearth of volatility demand and further bolstered by the reflexive dynamics characteristic of crypto volatility markets.

Amid escalating volatility selling and limited avenues for recycling long vol risk, dealer hedging activity attenuates spot price movements in both directions, spurring further vol selling in the absence of substantial catalysts. This sequence establishes a Lindy Effect in ETH vol markets, where increased volatility selling and reduced price movements perpetuate a pattern that's likely to continue.

If we broaden the lens, these factors collectively represent ETH's ongoing transformation into a yield asset, marked by staking yields and the harvesting of volatility risk premium. As the ETH volatility market navigates these changes, keep pace with Paradigm for more insights, and don't miss out on our latest Institutional Insights piece here.