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COC#8: Bitcoin’s 2021 Review Using On-Chain And Price Related Data
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Tag: Cycling On-Chain
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COC#7: The Bitcoin Market Hangs Between Hope And Fear
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COC#6: “Smart Money” Is Front-Running Retail
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COC#5: How January’s On-Chain Footprint Bent The Bitcoin Price Trend Twice
Dilution-proof, October 1st, 2021
Cycling On-Chain is a monthly column that uses on-chain and price-related data to better understand recent bitcoin market movements and estimate where we are in the cycle. This fifth edition first takes a brief look at factors that provided a headwind for the bitcoin price during September. We then zoom in on an array of on-chain metrics that saw a significant trend change around the January local bitcoin price top, which in hindsight also set a floor price for the recent downturn in the bitcoin market. This column closes off by reflecting on Bitcoin’s current on-chain supply dynamics and macro context.
September Headwinds
After two consecutive months of positive returns on bitcoin during the summer, September provided several headwinds that caused bitcoin’s price trend to mostly move downwards.
After an initial price increase at the start of the month based on positive market vibes related to El Salvador formally adopting bitcoin as legal tender, price crashed hard on “Bitcoin Day,” September 7, when the law went live. The intraday price range that day was -$10,352 (-19.56%), a steep decline that was partially caused by a domino effect of long liquidations that each triggered another forced sell-off that pushed the price down further, liquidating even more long positions. As can be seen in Figure 1, the funding rates (green) on September 7 weren’t as high as they had been in Q1 when market euphoria was still in full effect. However, open interest (blue) had increased quite a bit over the previous weeks and saw a steep drop due to the forced unwinding of over-leveraged longs.
Figure 1: Bitcoin price (black), perpetual futures funding (green) and open interest (blue), as well as the total short (red) and long (yellow) liquidations (source)
That event surely scared some market participants who had not experienced this before or did not understand the underlying mechanics. Subsequently, headlines that Chinese housing giant Evergrande might be on the verge of bankruptcy revived memories of Lehman Brothers collapsing at the start of the financial crisis of 2008. Equity markets saw a significant sell-off on September 20, which was also reflected in the bitcoin price (Figure 1).
Despite these headwinds, the bitcoin price closed just $3,302.45 (7.01%) lower than it opened the month of September, showing some resilience. The bullish on-chain supply mechanics that were described in Cycling On-Chain #4 are still intact, suggesting that patient investors with a low time preference are not selling at these prices. Of course these trends can certainly change, for instance if the current macroeconomic circumstances worsen, but based on on-chain trends, these dips can be considered potentially favorable buying opportunities.
To underline the last point, we’ll use this edition of Cycling On-Chain to zoom out a little and look at an array of on-chain trends that have been present since around the January local top, which was already pointed out in a Twitter thread in early May. We’ll then show that the price levels of that January local top actually also provided a technical price floor where the bitcoin price trend found support during the recent market downturn.
Cooled-Off Prices Since January
First, we’ll have a look at the Bitcoin Price Temperature (BPT). The BPT is a metric that essentially looks at the four-year volatility in the bitcoin price by calculating the number of standard deviations that the current price is from its four-year moving average. As can be seen in Figure 2, the bitcoin price increased rapidly in Q4 2020 (left grey arrow), which resulted in a local top on the BPT (black) at a temperature of 7 in early January.
Figure 2: Bitcoin price (grey) and the Bitcoin Price Temperature (BPT, black) (source)
Since then, bitcoin returns started to taper off (right grey arrow) and price temperature started to cool down as a result. This BPT cooling was then exacerbated by the mid-May price crash. Current prices are similar to those we saw during the January local top, but price temperature has cooled down to less than 2, illustrating that these prices are now much more normal on a four-year timeframe than they were in January.
Next, we’ll have a look under the hood and assess a series of on-chain trends that have significantly changed since that same January local top.
Declining Old Coin Movement
One of the trends that have changed since January is a decrease in the amount of relatively old bitcoin that is being moved on-chain, suggesting that sell pressure of experienced market participants is declining. This concept can be assessed using on-chain data in multiple ways.
Perhaps the purest approach is to simply look at the average age of each bitcoin that moves on-chain each day. This is done by a metric called “Average Spent Output Lifespan (ASOL)” that is illustrated in green in Figure 3. As can be seen, ASOL was increasing throughout the late 2020 bull run and clearly peaked around the January local top, after which it has been in a downtrend.
Figure 3: The bitcoin price (black) and the 7-day moving average of the Average Spent Output Lifespan (ASOL, green) and Dormancy (blue) (source)
However, not every on-chain transaction that moves necessarily holds equal weight when it comes to its potential impact on the bitcoin price. After all, a 1,000 BTC transaction has much more potential to influence price than a 0.001 BTC transaction does. This problem is solved by essentially correcting by the actual on-chain volume that was moved, resulting in a metric called “dormancy” that is displayed in blue in Figure 3. With he exception of a few outliers, dormancy has been in a steady downtrend since the January local top. Even more telling, it is currently at levels not seen since early 2017.
Remaining Long-Term Holders Are Now HODLing
Another way to utilize coin lifespan is to determine at what age an unspent transaction output (UTXO) becomes very unlikely to move again. Glassnode did so last year and found that at a coin age of above 155 days (roughly five months), unspent transactions are particularly unlikely to be moved again. As such, coins that haven’t moved for 155 days can be labeled “Long-Term Holder (LTH) Supply.”
Figure 4 displays the 30-day net position change of this LTH supply. As can be seen, coins that are more than five months old were increasingly being sold throughout the late 2020 bull run, as relatively experienced holders were selling into market strength. This sell trend peaked around the January local top, after which LTH sell pressure started to decline and has flipped to strong accumulation over the last few months — despite the steep price dip this spring and early summer.
Figure 4: The bitcoin price (black) and Long-Term Holder 30-day Net Position Change (green and red) (source)
Experienced market participants that were skeptical of Bitcoin’s price run towards and break of its previous $20,000 all-time high (ATH) sold heavily against market strength up to the January local top, whereas those that remained afterwards appear to have little intention of selling — again, despite the steep mid-May price drop.
Long-Term Holder Transaction Volume Is Declining
The LTH net position change that we dissected above illustrates the LTH supply dynamics, but it is also possible to assess LTH behavior by looking at their on-chain transaction volume. Figure 5 shows the transaction volume of coins that hadn’t moved in at least six months. The transaction volume of that cohort also peaked around the January local top and has been in a declining trend ever since, with the exception of a temporary spike during the July relief rally that likely consisted of previously trapped investors that were looking for exit liquidity.
Figure 5: Spent Volume Age Bands (SVAB) for coins with a lifespan of six months or more (source)
Bitcoin’s UTXO Set Is Aging
Besides the coins that are moved (“spent”) on-chain, it is also possible to look at the current status of all UTXOs that exist. This was first done by Dhruv Bansal, who divided Bitcoin’s UTXO set into brackets of different ages, creating a metric known as HODL Waves. This metric was later adjusted by @typerbole, who weighted each HODL Wave by the value each of UTXO when it was last moved on-chain, creating the Realized Cap HODL Waves that are basically a more expressive version of the original metric.
As can be seen in Figure 6, the Realized Cap HODL Waves of coins with an age of up to one month (red colors) trended upwards until the January local top, after which they have been in a steady decline. This shows that up to the January local top, older coins that were previously unspent were being moved on-chain, resetting their lifespan to zero and allowing the bands of the warmer colors in Figure 6 that represent relatively young coins to swell. Since January, these trends have cooled off considerably, allowing the bands of the cooler colors to recede, showing that Bitcoin’s UTXO set is aging again in aggregate.
Figure 6: Realized Cap HODL Waves (source)
Declining Miner Sell Pressure
On-chain data also allows skilled analysts to estimate which bitcoin are in the hands of miners. Throughout 2019 and 2020, this data showed that the bitcoin balances that were considered to be in miners’ wallets saw a steady uptrend. Right before the January local top, those balances declined steeply (Figure 7, green), which was followed up by relatively large amounts of bitcoin being sent from those miner wallets to exchanges (Figure 7, blue). Over the past six months, those trends have both reversed, suggesting that miner sell pressure is relatively modest again — despite the hard Chinese crackdowns on miners and resulting dramatic hash rate drop that we saw in May and June.
Figure 7: The bitcoin price (black), miner balances (green) and exchange deposits (blue) (source)
The May 19 Capitulation As The Next On-Chain Market Turnaround
The Chinese crackdowns on Bitcoin mining and Elon Musk’s tweet where he announced that Tesla would stop accepting bitcoin had a significant influence on the bitcoin price in the subsequent months. These events scared newer market participants and put an end to the overheated market conditions. This escalated on May 19, where a cascade of long liquidations introduced bitcoin’s first -$10,000 intra-day price move that ended the speculative mania and marked the next large turnaround in bitcoin’s on-chain market structure. The market was cleared from its excess leverage and speculation and the coins of these “weak hands” started moving into strong hands.
Where most of the on-chain metrics that we discussed before provided little to no warning of what was coming, Glassnode’s illiquid supply metric did. By applying algorithmic on-chain forensics, Glassnode estimates which coins are likely in the hands of the same entity. Since Bitcoin’s blockchain is a distributed ledger in which every single bitcoin transaction that was ever made is recorded, Glasnode can look at the spending history of those entities. Entities that flip their coins around all the time (e.g. active traders) are labeled “highly liquid,” those that do so in a slightly more relaxed fashion are labeled “liquid” and the remaining group that has little to no history of moving accumulated coins is labeled “illiquid.”
Figure 8 shows the 30-day net change of that illiquid supply. After the drop from the current $65,000 ATH in late April, a significant decreasing illiquid supply was reported, suggesting that previously illiquid entities were seeking exit liquidity during the early May relief bounce. Elon Musk’s tweet on May 12 and the consecutive Chinese crackdowns then put fuel on the fire, exacerbating a significant price drop that ended in a capitulation event on May 19, which had a similar cascading long-liquidation footprint as was seen in Figure 1.
Figure 8: The bitcoin price (black) and 30-day Illiquid Supply Change (source)
That May 19 selloff marked the capitulation of short-term bitcoin price speculators and flushed the market from its excess leverage.
Favorable Bitcoin Supply Dynamics Since May 19
The large amount of previously illiquid coins that were thrown on the market were gradually accumulated by more convinced investors with a lower time preference. A re-accumulation zone was born. Since the May 19 capitulation event, the percentages of all circulating bitcoin supply that are not held not on exchanges (Figure 9, blue) and that are illiquid (green) or are part of the LTH supply (red) are all in an uptrend.
Figure 9: The bitcoin price (black) and the percentages of the circulating supply that are not at exchanges (blue), labeled as illiquid (green) and labeled Long-Term Holders (red) (source)
With a market that is cleared from speculators and excess leverage, these underlying on-chain supply dynamics are the remaining elephant in the room when it comes to estimating where the bitcoin price moves next.
It is important to realize that the trends of these metrics can suddenly turn around and paint a very different picture, as we saw during the mid-May selloff. Therefore, it is not possible to necessarily predict future bitcoin price movements based on these historical trends.
However, the on-chain data is currently very clear in telling us that experienced market participants are in aggregate not looking to sell within the current market context. If these trends continue, it means that an increasing portion of the bitcoin supply is being held by investors with relatively strong hands. Due to Bitcoin’s inelastic supply, this means that if bitcoin demand does increase again, it will be increasingly difficult to buy bitcoin at current prices, as only a limited set of current holders are looking to sell. This is known as a supply shock.
If such a supply shock is indeed forming, it is a bit like holding a beach ball under water while it is being inflated. You can keep the ball under water for a while, but if you slip for just a moment or if the ball is inflated to the point where you can no longer hold it, the ball shoots out of the water. Time will have to tell if current on-chain trends are indeed indicative of the bitcoin beach ball currently being inflated while being held under water, where all dips at this point are being bought — or whether a change in context will (temporarily) deflate the ball and lower its thrust potential.
January Local Top Prices Setting A Technical Price Floor
As mentioned before, the bitcoin price levels related to the January local top and its correction provided key support and resistance levels during the recent market downturn (Figure 10). The May 19th capitulation and cascading long-liquidation event bounced exactly on the price level where the bitcoin market found support (~$30k) after its pullback from the January local top. The price levels of the actual January local top (~$40k) ten provided a clear resistance zone during the subsequent relief bounce(s).
After a supply squeeze was formed between the May 19 capitulation event and mid-July and some of the remaining trapped bears exited their positions during the late-July relief bounce (which we discussed in Figure 5), the $40,000 January local top resistance zone is now being tested for support.
Figure 10: The bitcoin price on Bitstamp and the zones reflecting the top (orange) and bottom (green) of the January local bottom (source)
Have enough STH speculators with weak hands and LTH that wanted to sell below the key $40,000 resistance zone done so for this level to now provide a key support zone?
Figure 11 shows the amount of bitcoin that was moved on-chain at each price level. We can see that a lot of coins moved around the $30,000 and $40,000 price levels, providing further evidence to the claim that these zones are potentially important levels to watch.
Figure 11: Bitcoin’s Unrealized Transaction Output (UTXO) Realized Distribution (URPD) (source)
Potential Macroeconomic Threats
As mentioned several times throughout this column, while the on-chain trends that are described appear to be quite strong, they can shift the mid- to long-term perspective for the bitcoin price. Current uncertainties in the overarching macroeconomic environment may provide a direct cause for that.
Since June, the U.S. Federal Reserve started mentioning that they are considering, at some point in the future, to turn off some of their money printing presses. Some investors believe that they will not be able to do so without creating havoc in the economy, but the increasing dollar currency index (Figure 12, red/green) since then suggests that others have started to adopt a “risk off” mindset. The more recent uncertainties related to Evergrande, the Chinese housing giant that may be on the verge of bankruptcy, caused even more uncertainties in equity markets, increasing the rotation of money from equities into cash.
Figure 12: The S&P500 (SPX; black/white) and United States Dollar Currency Index (DXY, red/green) (source)
If macroeconomic circumstances do worsen during the upcoming period and the broader financial markets increasingly go “risk off,” causing an equities selloff, it is likely that the bitcoin price will drop alongside it. If that does happen, it will be very interesting to observe to what extent the on-chain trends that were described in this article remain intact, causing any bitcoin price dips to be bought up quickly. Or conversely, whether experienced market investors will actually start exiting their positions, potentially resulting in a more significant bitcoin bear market.
Current Market Sentiment
I hold a monthly bitcoin market sentiment poll on Twitter. Although the results of such polls always need to be interpreted with a grain of salt due to selection bias, this month’s poll suggests that a portion of the market still has high expectations for the bitcoin price development over the upcoming year (Figure 13).
Figure 13: Results of a monthly market sentiment poll on Twitter (source)
Halving Cycle Roadmap
As always, I like to close off this edition of Cycling On-Chain by looking at the Bitcoin Halving Cycle Roadmap for 2020-2024 (Figure 14). This chart visualizes the current bitcoin price, overlayed with the BPT that we discussed above and with price extrapolations based on two time-based models (dotted black lines) — the Stock-to-Flow (S2F) and Stock-to-Flow Cross Asset (S2FX) model (striped black lines) — and cycle indexes for cycles 1 and 2 (white lines) and the geometric and arithmetic averages of those (grey lines). All these models have their own statistical limitations, but together they give us a rough estimate of what may be ahead for the bitcoin price if history does turn out to rhyme once again.
Figure 14: The Bitcoin Halving Cycle Roadmap
Previous editions of Cycling On-Chain:
Disclaimer: This column was written for educational, informational and entertainment purposes only and should not be taken as investment advice.
This is a guest post by Dilution-proof. Opinions expressed are entirely their own and do not necessarily reflect those of BTC, Inc. or Bitcoin Magazine.
COC#4: On-Chain Silence Before The Storm
September 1, 2021
Cycling On-Chain (COC) is a monthly column that uses on-chain and price-related data to better understand recent market movements and estimate where we are in bitcoin’s market cycle. This fourth edition briefly reflects on the recovering hash rate and then takes a more in-depth look at the relatively low on-chain transfer activity on Bitcoin. After introducing several contributing factors, we discuss to what extent low on-chain activity is reflective of market demand for bitcoin (the asset) or whether monitoring HODLing behavior is actually more useful in the context of bitcoin’s value proposition.
Two months ago, in COC #2 (July 1, 2021), we pointed out two important factors that needed a bit of time to settle, before potentially creating a favorable situation for Bitcoin from a fundamental perspective later this summer — which is now starting to unfold. One was the El Salvador government making bitcoin a legal tender in their country, which is now set to go into effect next week (September 7, 2021).
The other was the major crackdowns on bitcoin by the Chinese government, driving miners out of their country, potentially actually improving the geological distribution of bitcoin mining activity that was heavily concentrated in China up to that point. Some feared a hostile takeover (a 51% attack) of the network by the Chinese government, which has not happened (yet?).
Hash Rate Recovery
After reaching a low of 89 TH/s on July 9, 2021, the two-week moving average of Bitcoin’s hash rate has already recovered to 127 TH/s (+43%) since then, as Bitcoin’s difficulty needed to be increased three times in a row to account for the new hash rate. It is unknown to what extent this hash rate is miners that relocated from China or actual new miners, but it is a positive sign either way. Figure 1 displays the bitcoin price (black) and difficulty (green), as well as the 14-day moving average of its hash rate (red) and number of blocks mined (purple).
Figure 1: Bitcoin price (black), difficulty (green) and the 14-day simple moving average of its hash rate (red) and number of blocks mined (purple) (Source).
After the massive drop in Bitcoin’s hash rate during May and June, the hash ribbon indicator signaled severe miner capitulation. Now that the hash rate is recovering, figure 2 shows that the 30-day moving average of Bitcoin’s hash rate (green) has crossed the 60-day moving average (blue) to the upside. This bullish crossover on the hash ribbon indicator is interpreted as a buy signal, as this type of hash rate recovery after miner capitulation has historically preceded subsequent price increases.
Figure 2: Bitcoin price (black) and the hash ribbons indicator that consists of the 60-day (blue) and 30-day (green) moving averages of the Bitcoin hash rate (Source).
Block Space Galore
One implication of the rapidly rising hash rate during this recovery period is that many more blocks are being created than normally would be. After all, Bitcoin’s difficulty adjustment mechanism adjusts every 2,016 blocks (~two weeks), but if hash rate rises steeply throughout that period, Bitcoin block creation is like a runaway train. Logically, when more blocks are created, it means that there is more block space available to include transactions.
Besides this actual (temporary) increase in available block space, the adoption of several Bitcoin technologies that optimize block space usage (so effectively, scaling) means that every bit of block space is also starting to be used more efficiently. One example of this is transaction batching, where exchanges combine many transactions into one, limiting their claim on Bitcoin block space and thus also their own transaction fees.
Another example is Segwit adoption, which saw a large increase recently (figure 3). Segwit transactions segregate the signature data from bitcoin transactions, which effectively allows more transactions to be included within each block.
Figure 3: Bitcoin Segwit adoption (Source).
This recent surge is the result of Blockchain.com, a semi-custodial wallet and exchange platform that is under scrutiny within parts of the Bitcoin community, finally upgrading its software — four years after Segwit became available. Since Blockchain.com is estimated to account for ~33% of the bitcoin transactions, this action effectively takes away a large chunk of the market demand for Bitcoin block space, leaving more room for everyone else. (Fun fact: This also means that Blockchain.com has been overpaying for transaction fees for nearly four years, effectively subsidizing bitcoin miners all this time.)
Lightning Network Adoption
When it comes to optimizing the number of real-world transactions that can be fitted into a Bitcoin block, Layer 2 technologies like the Lightning Network are much more promising than any existing on-chain scaling solution. By using a smart-contract-like solution on Bitcoin, the Lightning Network allows users to open up a payment channel and send an infinite number of transactions (within the limitations of the available funds off course), limiting the used block space of all those transactions to just two on-chain transactions to open and later close the channel.
As can be seen in figure 4, Lightning Network adoption is absolutely soaring right now, as for example the number of public nodes, the number of public channels and the value within those channels are going parabolic. The Lightning Network is going to play an important role in El Salvador’s bitcoin adoption as well, which means that this Lightning Network adoption will likely continue to grow in the upcoming years.
Figure 4: Several Lightning Network adoption metrics (Source).
Finally, it should be pointed out that other Layer 2 technologies than Lightning exist. An example is Blockstream’s Liquid Network, but to some extent custodial solutions like those of large players like Square, PayPal and Visa that (plan to) allow their users to make BTC-denominated transactions. Skeptics would rightfully point out that using a custodial solution is not using bitcoin but a bitcoin IOU, but the existence of these services impacts the demand for Bitcoin block space nonetheless within the context that we’re discussing here.
Cooled Down Block Space Market
As a result of the hash rate recovery and lowered block space demand due to the recently increased adoption of Segwit and the Lightning Network, the supply of available block space has increased. At the same time, the bitcoin market saw a large price downturn that scared away a lot of speculators, also lowering the demand for block space as there are less entities looking to transact on-chain. During this period, the Bitcoin mempool (the queue of transactions that are waiting to be confirmed) has gotten a chance to clear — and has stayed nearly empty over the last couple of weeks (figure 5).
Figure 5: The Bitcoin mempool according to mempool.space (Source).
As with any market, a supply shock where an increase in the market-available supply is combined with a decrease in market demand, prices drop. This also applies to the Bitcoin block space market, where transaction fees have recently dropped to levels that are even below those of the 2018–2019 bear market (figure 6). This figure, therefore, also shows that it is not just demand for block space being lower after the price drop that caused the on-chain silence, as surely there are more entities looking to transact now than at the depth of that previous bear market.
Figure 6: The 14-day moving average of the median bitcoin transaction fee (Source).
This chain of events is quite unique in Bitcoin’s history, both fundamentally, in terms of actual scaling solutions being adopted, and in terms of the divergence between the trends in the bitcoin price, and Bitcoin’s underlying on-chain activity.
The low transaction fees are concerning to some, as Bitcoin’s long-term security model depends on transaction fees overtaking the block subsidy as the primary source of miner revenue. Although I agree with that statement, I do believe that we have a lot more time to find an appropriate equilibrium in Bitcoin’s block space market.
Mining Is Still (Very) Profitable
A short-term example for this is that the current (USD-denominated) miner revenue per hash is already close to the yearly highs again (figure 7). China’s hard crackdowns were painful for Chinese miners, but thanks to Bitcoin’s ingenious incentive structure, their pain was actually someone else’s gain. Thanks to the actions by the Chinese government in combination with the global chip shortages that are limiting opportunities of competing mining operations to come online, bitcoin mining is actually very profitable right now — despite only ~1.3% of their current revenue coming from transaction fees.
Figure 7: Bitcoin miner revenue (in USD) per hash (source)
When it comes to Bitcoin’s long-term security guarantees, we should zoom out, as the adoption of bitcoin (the asset), Bitcoin (the system) and related technologies such as the Lightning Network guarantee volatile times in bitcoin-related markets — both for the bitcoin market and the Bitcoin block space market.
Low Demand For Block Space Does Not Equal Low Demand For Bitcoin
When on-chain activity increases a lot within a short timeframe, it means that there is a clear increase in the demand to move bitcoin around on-chain. Since part of that demand could come from investors looking to buy or sell their position, such spikes could certainly be related to short-term price volatility, including increased demand for bitcoin.
However, the opposite is not necessarily true. As shown in figures 3 through 6, a decrease in on-chain transfer volume can also be the result of scaling technologies. To further support this claim, figure 8 shows that the total bitcoin transfer volume per entity on the network has been in a steady decline ever since Bitcoin’s infrastructure has seen significant maturation improvements (introduction of futures markets and many new exchanges, Segwit, Lightning, Liquid, etc.).
Figure 8: The 14-day moving average of the entity-adjusted total transfer volume on Bitcoin (Source).
The significance of this trend for the interpretation of transaction-related, on-chain metrics should not be understated. A popular example of this is the Network Value to Transactions (NVT) ratio that we’ll take a closer look at.
How Bitcoin Scaling Is Skewing The NVT Ratio
The Bitcoin NVT ratio was introduced by Willy Woo in February 2017 as a Bitcoin-alternative to the price-per-earnings (PE) ratio that is used in (value) stock investing. By introducing the NVT ratio, Woo not only introduced an interesting new metric but essentially started the on-chain analysis sector that has become very popular since then. The NVT ratio is calculated by dividing Bitcoin’s market cap by its daily transfer volume (USD) and is displayed in figure 9.
Figure 9: Bitcoin Network-Value-to-Transactions (NVT) Ratio (Source).
As was already discussed, since the introduction of this metric, a number of scaling solutions have been adopted that are lowering the amount of on-chain transfers per entity, and thus the “T” part of the NVT ratio. Figure 10 displays a 365-day moving average of the entity-adjusted transfer volume that we introduced in figure 8 (green), as well as the 365-day moving average of the NVT ratio (orange).
Figure 10: The bitcoin price (black) and 365-day moving averages of the NVT ratio (orange) and entity-adjusted transfer volume (green) (Source).
Figure 10 also shows that since early 2013, the NVT ratio has been in a general uptrend, with a temporary decrease during the 2016–2017 bull market, where the NVT ratio decreased as Bitcoin’s on-chain transaction volume outpaced its market cap growth. During the 2020–2021 bull market, such a temporary decline did not happen, as the adoption of scaling technologies limited the on-chain footprint of the recent influx of new investors.
Under the assumptions that the adoption of the Lightning Network and infrastructure that has a similar impact in limiting the on-chain footprint per transaction will continue and the bitcoin price also keeps increasing, the NVT ratio can be expected to keep trending up over time.
In theory, the NVT ratio can still be a relevant metric to assess more short-term changes in the ratio between bitcoin market valuation and transaction volume, but within that context it is only stable on timeframes where the adoption of scaling technologies is also stable. Either way, analysts should be careful to still use the NVT ratio within the context of more long-term bitcoin price valuation strategies.
Does ‘Using’ Bitcoin Mean Transacting Or HODLing?
On a more philosophical level, one can also wonder if a ratio of the total bitcoin market valuation and its transaction volume is actually the right metric to look at within the context of Bitcoin’s overarching value proposition. Historically, there are two schools of thought regarding Bitcoin’s ultimate use case.
The first one considers Bitcoin to primarily be a censorship-resistant medium of exchange, and thus for transacting bitcoin to indeed be its ultimate use case. Within that frame of mind, the idea behind the NVT ratio indeed is quite reflective of Bitcoin’s relative valuation compared to its ultimate use case.
The second school of thought considers Bitcoin to primarily be a store of value — a dilution-proof money that is designed to maintain its purchasing power over time. Within that frame of mind, HODLing bitcoin is its ultimate use case, whereas transacting it is more of an occasional (yet still essential) functionality. Within that mindset, it is not transaction volume but investor time preference and hardiness to hold onto the asset that are central in its value proposition.
Looking at Bitcoin from that perspective, current “usage” does not look bleak at all.
HODLing Is On The Rise Again
Figure 11 displays the long-term holder (LTH) and short-term holder (STH) supply as a percentage of the circulating bitcoin supply. In this figure, any existing bitcoin is quantified as LTH supply when it has not moved on the blockchain in 155 days or more (~five months).
Figure 11: LTH and STH supply as a percentage of the circulating bitcoin supply (Source).
The supply that is in the hands of long-term holders has been fairly constant at around 50–75% of the total supply (excluding bitcoin that is estimated to be lost). The percentage of STH supply has been on a downtrend since bitcoin first received a market price, but temporarily increases during euphoric market conditions that attract new investors.
During the 2020–2021 bull market we also witnessed a clear decrease in LTH supply and increase in STH supply, which has almost completely retraced to pre-bull-market levels. This re-accumulation of bitcoin by long-term holders is, in itself, not necessarily a short-term signal for a market turnaround but has historically shown to often coincide with price levels that end up forming a price floor.
Using coin-aging as a mechanism to estimate HODLing behavior is useful but leans on some assumptions that make it a somewhat broad estimation. Due to the transparent nature of the Bitcoin blockchain, it is (unfortunately, from a privacy perspective) possible to track the actual on-chain flows and identify certain groups of addresses that belong to the same entity. By doing so, it is possible to estimate how much percent of the total bitcoin supply is not on exchanges (figure 12, blue) and how much percent of the total bitcoin supply is in the hands of illiquid entities that have no history of selling (figure 12, green). (For advice on how to improve your own Bitcoin-related privacy and limit your own on-chain traceability, make sure to check out @BitcoinQ_A’s awesome “Bitcoin Privacy Guide.”)
Figure 12: The illiquid and non-exchange supply as a percentage of the total circulating bitcoin supply (Source).
Figure 12 clearly shows that during the market sell-off in May 2021, a good chunk of previously illiquid supply suddenly became liquid again (drop in green line) and that coins that were previously not on exchanges were sent there (drop in blue line). However, both trends have already retraced close to their pre-sell-off levels. This shows that the bitcoin that was dumped on the market during market uncertainty have likely already been re-accumulated into the hands of investors that are less likely to be shaken out of their positions.
Overall market demand for bitcoin is likely not as high as it was during the euphoric times that we saw at the start of the year. However, the bitcoin market appears to be in a state where if something sparks new bitcoin demand, the relatively low amount of market-available supply means that it could spark a rapid price increase (supply shock).
On the flipside, if something does trigger a significant portion of these long-term holders with a relatively illiquid market behavior history to sell their coins, the bitcoin price could rapidly move down as well. Monitoring these metrics is, therefore, necessary to pick up possible trend changes that could signal a market turnaround.
Signs Of A Cooled Down Bitcoin Market
The market downturn over the last few months has given the bitcoin price a chance to significantly cool down on a relative basis. One metric that gives a rather direct estimate of this is the Bitcoin Price Temperature (BPT), which compares the current bitcoin price to its four-year moving average (figure 13, blue line). Price temperatures of two (green), six (orange) and eight (red) have historically signaled possible market turnarounds. At the start of the year, the price bounced off the BPT6 band multiple times before retracing. The current BPT is just above two, despite being at similar price levels to the much higher temperatures that we saw at the start of the year, illustrating how the bitcoin price has cooled off on a relative basis compared to its own four-year market cycle.
Figure 13: The Bitcoin Price Temperature (BPT) Bands.
A similar conclusion can be drawn when looking at the funding rates in perpetual bitcoin futures. These funding rates can be seen as a general proxy for the extent in which futures markets are long (funding >0) or short (funding <0). Figure 14 shows that, during the recent market downturn, funding rates went from extremely positive to extremely negative, illustrating a clear shift in market sentiment. The recent local bottom funding rates have turned slightly positive again, but they are very modest in comparison to what we saw around the start of the year, suggesting that the speculative markets are not as overextended as they were back then.
Figure 14: Funding and open interest in perpetual bitcoin figures (Source).
Whales Are Liking The Discount
This recent re-accumulation period appears to be particularly attractive for relatively large market players (whales). Figure 15 visualizes the bitcoin price, overlayed by blue bubbles that represent large (1,00010,000 BTC) bitcoin addresses that saw capital inflows at those price levels.
Figure 15: Large bitcoin address (1,000–10,000 BTC) inflows (Source).
Two things stand out in figure 15: (1) the 2020–2021 cycle has more large wallet (1,000–10,000 BTC) inflows than the peak of the 2017 cycle, and (2) inflows during the recent price bounce over the last month have been fairly high in comparison to the rest of this cycle.
Current Market Sentiment
I hold a monthly bitcoin market sentiment poll on Twitter. Although the results of such polls always need to be interpreted with a grain of salt due to possible selection bias, this month’s poll suggests that (a portion of) the market still has high expectations for the bitcoin price development over the upcoming year (figure 16).
Figure 16: Results of a monthly market sentiment poll on Twitter (Source).
Halving Cycle Roadmap
As always, I like to close off this edition of Cycling On-Chain by looking at the Bitcoin Halving Cycle Roadmap for 2020–2024 (figure 17). This chart visualizes the current bitcoin price, overlayed by the BPT that we discussed above and with price extrapolations based on two time-based models (dotted black lines), the stock-to-flow (S2F) and stock-to-flow cross asset (S2FX) model (striped black lines) and cycle indexes for cycles 1 and 2 (white lines) and the geometric and arithmetic averages of those (gray lines). All these models have their own statistical limitations, but together they give us a rough estimate of what may be ahead for the bitcoin price if history does turn out to rhyme once again.
Figure 17: Bitcoin Halving Cycle Roadmap (2020–2024).
Previous editions of Cycling On-Chain:
Disclaimer: This column was written for educational, informational and entertainment purposes only and should not be taken as investment advice.
This is a guest post by Dilution-proof. Opinions expressed are entirely their own and do not necessarily reflect those of BTC, Inc. or Bitcoin Magazine.
COC#3: Squeezed Supply, Shorts and Bitcoin Lemonade
Cycling On-Chain #3: Lemonade
Dilution-proof, August 1, 2021
Cycling On-Chain is a monthly column that uses on-chain and price-related data to better understand recent market movements and estimate where we are in bitcoin’s larger market cycle. After providing a broader look back and forward in the first edition, and discussing how Bitcoin has entered the geopolitical stage in the second edition, we’ll now take a look at the current, ongoing supply squeeze that recently led to a short squeeze in the bitcoin market that drove prices up steeply.
The last three months have been pretty rough for bitcoin from a price perspective. You could make a good case that, fundamentally, things have never looked better. But a period of over-leveraged speculation and (mostly irrational) fear in the markets have left their mark — particularly on the newer market entrants. Those times might be scary but are actually where the wheat is separated from the chaff or, in bitcoin terms, the weak hands are shaken out and the bitcoin ends up in strong hands. These HODLers of last resort don’t budge when price drops a double-digit percentage, but rather see it as an opportunity.
When life gives you melons, make lemonade – Elbert Hubbard, 1915
Lemonade. That is what this third Cycling On-Chain is all about. Times have been tough, but there are currently all kinds of squeezing going on that ensure that much of the available bitcoin supply will end up in strong hands in preparation for the next micro-, meso- or macro-cycle.
Squeezing Supply
A supply shock, sometimes also called a supply squeeze, is an event where the supply of a product or commodity that is actively being traded on the market changes and causes a price move. In Bitcoin, the halving events that occur every 210,000 blocks (roughly every four years) are the most famous supply shocks. During a halving the new supply issuance via the block rewards that miners receive when creating a new block is halved, triggering a large price increase in the subsequent year that is known as Bitcoin’s four-year cycle.
Bitcoin’s halvings are programmed into the software, but a supply shock can also occur when previously illiquid supply becomes liquid or vice versa. It is therefore interesting to assess to what extent supply is in the hands of entities that are or are not selling.
Using the data in the Bitcoin blockchain, it is possible to look at the ages of all the unspent transaction outputs (UTXOs) that have ever existed. Glassnode analyzed these “coin ages” and found that roughly 155 days is a historic cut-off point when the probability of a UTXO being spent becomes very low. Based on this, they created metrics for the short-term holder (STH) and long-term holder (LTH) supply.
Figure 1: Bitcoin price (black), circulating supply (blue), short-term holder supply (red) and long-term holder supply (green) (source)
As is evident, the STH and LTH supply fluctuate over time. An easier way to view the historical data is to divide the LTH supply by the circulating supply, which then represents the portion of the circulating supply that is estimated to be in the hands of LTH.
This Long-Term Holder Supply Ratio is displayed in the green line in Figure 2. The green color overlays represent periods in which the LTH Supply Ratio rises, which usually occurs during market downturns where price (black line) decreases or bottoms. The red color overlay shows the opposite: LTH Supply Ratio usually decreases when price rises, illustrating that long-term holders tend to sell against market strength and accumulate during market weakness. Long-term bitcoin holders are therefore usually seen as “smart money.” Being able to follow their economic behavior via the blockchain may hold valuable information about the state of the bitcoin market.
Figure 2: Bitcoin Long-Term Holder (LTH) Supply Ratio (green) and price (black) over time (source)
The LTH Supply Ratio also allows us to compare how current values for the portion of the total supply that is held by long-term holders compares to historical values. Figure 3 illustrates that the lowest LTH Supply Ratio reached during this latest $65,000 market top was not as low as those reached during previous market cycle tops. Of course it does not have to reach these levels, but shows that if $65,000 does end up being a larger macro market cycle top, it was characterized by lower LTH sell pressure than previous market cycle tops.
Figure 3: Bitcoin Long-Term Holder (LTH) Supply Ratio (green) and price (black) over time (source)
Since the Bitcoin blockchain is a public ledger, it is also possible to forensically assess to what extent unspent transactions come from or move to certain types of entities, such as exchange wallets. While this is unfortunate from a privacy perspective (make sure to check out @BitcoinQ_A’s privacy guide to learn how to optimally deal with this yourself), it allows Glassnode to improve upon the STH and LTH supply metric.
Using a proprietary algorithm to apply clustering based on forensic analysis of Bitcoin’s UTXO set, they created metrics for the illiquid, liquid and highly liquid supply. For the remainder of this column, the latter two are combined as “liquid supply” to keep the analysis simple.
Figure 4: The bitcoin price (black), circulating supply (blue), illiquid supply (green) and sum of the liquid and highly liquid supply (red) (source)
If you compare the original STH and LTH supply (Figure 1) with this illiquid and liquid supply chart (Figure 4), you’ll see that the changes in the latter are much more nuanced. This is likely the result of the applied clustering, as young UTXOs can still be held by illiquid entities with little to no history of selling.
Therefore, it is more helpful to look at the monthly net changes within these metrics, which is what Glassnode offers in their “Illiquid Supply Change” and “Liquid Supply Change” metrics. Figure 5 displays the illiquid supply change over time. The large amount of previously illiquid supply that became liquid around early May is clearly visible here, as well as the illiquid supply increases that have returned since the May 19 capitulation event.
Figure 5: The monthly (30-day) net change of bitcoin supply held by illiquid entities (source)
Because the bitcoin supply is increasing by every block and these increases are changing over time due to the halving-based supply issuance schedule, these values cannot be accurately compared to historical values. After all, a 200,000 bitcoin illiquid supply decrease was much more impactful when there were only 2 million bitcoin circulating (10% of the total) than it would be when there are 20 million coins circulating (1%).
This problem can be solved by dividing the illiquid supply by the circulating supply, creating a metric called the circulating supply-adjusted illiquid supply changes,” which is displayed in Figure 6. During the early years, the illiquid supply increased massively, a lot of which was likely related to coins being forgotten about or lost, as well as some of the early HODLers stacking sats before that became a thing. The relative illiquid supply decrease seen during the recent market downturn was the largest since the 2017 market cycle top, which was preceded by two more similar episodes during that bull run. The current illiquid supply increase is also the largest since mid-2017, before that cycle reached its final blow-off top.
Figure 6: The bitcoin price (black) and 30-day illiquid supply changes (green), adjusted for bitcoin’s circulating supply (source)
Recently, Will Clemente and Willy Woo introduced the “illiquid supply ratio,” a metric that is calculated by dividing Glassnode’s illiquid supply by liquid and highly liquid supplies. An alternative version that is best labeled as “illiquid supply percentage” can be calculated by dividing the illiquid supply by bitcoin’s circulating supply. The latter metric therefore represents the portion of the circulating supply that is currently labelled as illiquid by Glassnode. Likewise, the liquid supply percentage can be calculated by dividing the liquid supply by the circulating supply, representing the inverse of the illiquid supply. Both metrics are displayed in Figure 7.
Figure 7: The bitcoin price (black), circulating supply (blue), illiquid (green) and liquid supply (red) percentages (source)
Next we’ll zoom in on the illiquid supply ratio percentage, which is visualized in figure 8. After Bitcoin’s genesis almost all of the bitcoin supply was considered illiquid, as network participants were CPU mining on laptops and desktops and mostly just toying around with the new software. When bitcoin started getting a market price and saw some early adoption as a neo-money, a larger portion of the supply started to become liquid, as these coins could now actually be spent. During the earlier years miners also may have been selling their newly mined bitcoin to cover overhead costs — especially after the introduction of GPU mining and later ASIC mining.
Figure 8 also shows that after each Bitcoin halving (vertical black striped lines), the rate of contraction in the illiquid supply slows — even turning into a positive growth rate immediately after the last two halvings. More simply put: as the bitcoin supply issuance declines and it becomes scarcer, its holders appear to become less and less inclined to part with their bitcoin. Will the low 70% illiquid supply ratio percentage that we saw during the previous bear market be the lowest ones that will ever be reached in Bitcoin’s existence?
Figure 8: The bitcoin price (black) and illiquid supply ratio (green) over time (source)
Figure 9 shows this same illiquid supply ratio percentage, but zooms in on the last year. Since the start of July, the illiquid supply ratio percentage increased drastically, as coins were being scooped off the market at a discount by holders with a history of being strong hands. Current illiquid supply ratio percentage values haven’t been seen since the bitcoin price was hovering just below all-time highs at around $55,000. This short-term trend suggests that the recent dump is now over and a new supply squeeze may be underway.
Figure 9: The bitcoin price (black) and illiquid supply ratio (green) over time (source)
Squeezing Shorts
The supply wasn’t the only thing being squeezed recently. Since the May 19 capitulation event, the bitcoin price has been in a downward consolidation and market sentiment was predominantly bearish. Bitcoin Twitter was actually so salty that you could mine salt by scrolling through the responses under the tweet of any on-chain analyst. This was also noticeable in the funding rates of bitcoin perpetual futures contracts that were mostly negative since then, which means that shorting bitcoin was so popular that you would basically need to pay a premium to go short. The increasing open interest since the May 19 capitulation while funding stayed negative further substantiates this.
These circumstances lined up to be ideal for a short squeeze to occur. A short squeeze happens when a relatively large portion of the futures market is going short with inappropriate risk management and a sudden price increase causes the collateral under these positions to become insufficient, triggering exchanges to liquidate these positions. This is particularly troublesome if a large portion of the open positions are naked shorts, which means that they use a different form of collateral to borrow the asset they’re shorting against. In the case of bitcoin, when fiat currencies or stablecoins are used as collateral for a short position that is then liquidated, the fiat or stablecoin collateral is used to buy the bitcoin that is needed to pay off the debt, which actually drives its price up further.
This is exactly what happened over the last two weeks. Figure 10 illustrates that since the May 19 capitulation event, price declined (black) while open interest (blue) increased, as funding remained negative (light green). When price resiliently bounced off the recent $30,000 lows, open interest actually increased further at increasingly negative funding, showing that the bears were basically doubling down. However, the bitcoin price just kept surging, liquidating a large number of these naked shorts, creating an over $10,000 price move over the course of about a week.
Figure 10: The bitcoin price (black), perpetual futures funding (light green), perpetual futures open interest (blue) and short liquidations (red) (source)
Squeezing Out The Weak Hands
During this recent bounce off the lows, the Average Spent Output Lifespan (ASOL) per entity on the network remained low, which means that the coins that moved on the bitcoin blockchain throughout this period were mostly relatively young. The Spent Output Profit Ratio (SOPR) per entity on the network did increase though, illustrating that the coins that were moved did so at a profit. This combination of trends is visualized in figure 11 and suggests that younger market entrants that were sitting on underwater positions might have jumped on this opportunity to sell some of their positions at a profit. This is once again an example of coins moving from weak-handed entities with low conviction to strong-handed new owners.
Figure 11: Entity-adjusted Spent Output Profit Ratio (SOPR) and Average Spent Output Lifespan (ASOL) over time (source)
When using terms like “smart money” and “weak hands,” we tend to consider institutional players to be the former and retail investors to be the latter, but this is not necessarily the case. Figure 12 displays the bitcoin supply that is held by entities with balances up to 1,000 bitcoin and shows that entities with balances of up to 1 bitcoin have been rigorously stacking sats throughout this entire bull run and never had a significant selloff. Entities with a balance between 1 and 100 bitcoin were selling portions of their stack since bitcoin broke its prior $20,000 all-time high until the May 19 capitulation event. But these smaller entities have been accumulating again since then. Entities with a balance of 100 to 1,000 bitcoin were mostly stacking when the bitcoin price neared its recent all-time high and have mostly sat on their positions ever since.
Figure 12: Bitcoin supply held by each entity tier, up to 1,000 bitcoin (source)
By definition, whenever there are buyers there are also sellers. On average, entities with balances up to 100 bitcoin were accumulating throughout the recent market downturn. They were therefore slowly depleting the highly liquid supply that was actively being traded on the markets, as we already saw in the illiquid supply changes. Since this last bounce off the $30,000 lows, almost 112,000 bitcoin have been withdrawn from exchanges (Figure 13), adding fuel to the fire that we may be in the midst of another supply squeeze.
Figure 13: Bitcoin balances on exchanges (source)
A Not-So-Sour Sentiment
The recent market turnaround seems to have had a noticeable impact on the market sentiment as well. In an informal monthly market sentiment poll, respondents were very clearly bullish on all timeframes, as can be seen in figure 14.
Figure 14: Bitcoin market sentiment poll, ending on July 31, 2021 (source)
These poll results appear to align with the Fear & Greed Index that scrapes multiple social media platforms and algorithmically assesses the sentiment in bitcoin-related posts. Throughout the recent downwards price consolidation it consistently signaled very high levels of fear and anxiety, but has now actually flipped to greed for the first time in a while (Figure 15).
Figure 15: The Crypto Fear & Greed Index (source)
During the last few months, an often-heard criticism of on-chain analysis was that it does not predict the future. While this is true, increased insight into what is happening under the hood of the system certainly helps us understand how the bitcoin market functions. Relatively unexpected events such as Elon Musk or Tesla suddenly speaking negatively on Bitcoin or China suddenly cracking down hard against it can impact the market at any point. However, these types of events occur during each four-year halving cycle, so zooming out and looking at the larger picture may be helpful in navigating the larger trends.
Several models have been developed to do so and use statistical approaches to predict the global direction of where the bitcoin price is headed, such as the S2F and S2FX models. Other indexes extrapolate price increases throughout previous halving cycles over the current period. Each of these approaches have their own methodological limitations, but together they provide a nice overview of where price may be heading if history either repeats or rhymes (Figure 16). On average, the bitcoin price was following those anticipated courses nicely throughout the current halving cycle, but has dipped below most of these models during the recent market downturn. Will this cycle end up being the one that breaks down several of these models to the downside or will the apparent ongoing supply squeeze drive up this cycle’s price in line with its predecessors?
Figure 16: The Bitcoin Halving Cycle Roadmap (2020-2024)
Previous editions of Cycling On-Chain:
Disclaimer: This column was written for educational, informational and entertainment purposes only and should not be taken as investment advice.
This is a guest post by Dilution-proof. Opinions expressed are entirely their own and do not necessarily reflect those of BTC, Inc. or Bitcoin Magazine.
Cycling On-Chain #2: Bitcoin Enters Geopolitics
Dilution-proof, July 1, 2021
Cycling On-Chain is a monthly series that uses on-chain and price-related data to better understand recent market movements and estimate where we are in bitcoin’s larger market cycle. After providing a broader look back and forward in the previous edition, we’ll now look at Bitcoin’s on-chain data through the lens of June’s two most impactful events that introduced Bitcoin to the geopolitical stage: China cracking down against Bitcoin while El Salvador accepts it as legal tender.
China Crackdowns
Since mid-April, China has played a large role in Bitcoin-related news. Following some coal mine accidents in Xinjiang, the Chinese government instituted a power blackout for a ‘comprehensive power outage safety inspection’ on April 15, 2021. Because that area was accounting for a relatively large part of Bitcoin’s overall hash rate (the computational power of miners that is used to create new blocks and secure the network), the blackouts severely slowed down the Bitcoin network for one or two weeks.
A month later on May 18, when Bitcoin’s hash rate had largely recovered, China banned its financial institutions from offering Bitcoin services. This drove further fear into a market that was already anxious after Elon Musk tweeted the prior week that Tesla would stop accepting bitcoin for payments out of environmental concerns.
China’s offensive stance against Bitcoin continued in early June. Reports emerged that China started actively censoring bitcoin and cryptocurrencies exchanges to slow down their adoption and, more importantly, shut down Bitcoin mining operations in Xinjiang. This was later followed up by similar reports in the Yunnan province on June 14, as well as in Sichuan four days later.
There is no fundamental reason why price should decline along with hash rate; hash rate follows price since that drives incentives by increasing or decreasing profit margins, but not the other way around. Nonetheless, the recent bitcoin price drop further cut into miners’ profit margins. This possibly exacerbated the hash rate drop due to miners that are running on older equipment and/or more expensive energy (temporarily) pulling their own plugs.
Figure 1 shows that since the blackouts instituted on April 15, Bitcoin’s hash rate has fallen by ~50% and is now at levels not seen since briefly after the May 2020 halving.
Figure 1: Bitcoin’s mean hash rate (orange) and the bitcoin price (black) over time.
Image source
The hash rate drop means that there is much less computational power trying to guess the same difficult random number, which significantly slows down the creation of new blocks. The magnitude of this can be seen in figure 2, which shows that the block intervals on June 27 were by far the largest since the start of 2010, illustrating how much Bitcoin has slowed down as a result of the hash rate drop.
Figure 2: Bitcoin’s mean block interval since the start of 2010.
Image source
The next difficulty adjustment, projected to happen on July 3, is expected to be a record-breaking -27.2% (figure 3), which provides a large and immediate increase in miner profitability, incentivizing miners to start or restart mining operations. Bitcoin will therefore continue to function as normal and will only have been temporarily slowed down as the result of these recent negative actions by China.
Figure 3: Bitcoin price (black), mean hash rate (green) and mining difficulty (blue) over time.
Image source
Experienced Bitcoin market participants know not to trust every report that comes out of China, but recently reports of Chinese miners relocating to more mining-friendly jurisdictions like Kazakhstan and Texas are piling up. However, with China now actively working on the implementation of their own Central Bank Digital Currency (CBDC) that increases their surveillance and control, a case can be made to take their current moves against Bitcoin more seriously.
While these actions surely have a large economic impact on Chinese miners, those miners will have no problems finding a new home. Due to global supply chains being severely slowed down during the COVID-19 pandemic, there are large worldwide chip shortages. The recent actions by the Chinese government actually exacerbated the Bitcoin mining equipment shortages as Bitmain, a Chinese company that is one of the largest producers of mining equipment, had to halt their sales.
Figure 4 shows that since the start of June, the amount of bitcoin in miner wallets (green line) dropped by 6,701 BTC (-0.37%), but that drop is quite modest compared to the 28,266 BTC (-1.54%) decline in miner wallets in the first months after breaking the $20,000 previous all-time high, selling into market strength. The amount of bitcoin that are being sent from miners to exchanges (blue line) is also very low right now, further illustrating that the impact of the Chinese crackdowns on miner sell pressure has been modest – at least so far.
Figure 4: Miner wallet bitcoin balances (green), miner wallet to exchanges bitcoin transfers (blue) and the bitcoin price (black) over time.
Image source
While this event certainly is very important from a fundamental perspective, its (potential) impact on the bitcoin market is overblown by many. Hash rate may stay low or even further decline as more Chinese miners shut down or relocate elsewhere, but it will likely come back sometime in the coming weeks to months as there is massive demand for their equipment and services. Even if hash rate doesn’t come back, Bitcoin’s beautifully designed internal difficulty adjustment mechanism will ensure that blocks will continue to be produced, while current hash rate levels are likely more than enough to keep the network secure. As the popular meme goes: honey badger don’t care.
If the Bitcoin network does indeed remain strong, China’s crackdowns against it will actually go down as a great example of Bitcoin’s anti-fragility. The whole point of a truly decentralized system is that you cannot ban that system – you can only ban yourself from using it. Hash rate moving away from China also lowers the impact of future recurring China FUD (Fear, Uncertainty & Doubt), as their potential control over the system will have actually decreased.
The magnitude of how historically abnormal the current situation is can also be seen in the Puell Multiple, which is a measure for how many bitcoin are issued on a given day in comparison to how many were issued on an average day over the previous year. As can be seen in figure 5, the large hash rate drop and resulting slowdown of Bitcoin block creation have caused the Puell Multiple to make its steepest decline ever. The Puell Multiple is now in the green zone, which has historically only been seen around market cycle bottoms and the 2020 halving.
Figure 5: The Puell Multiple.
Image source
Although the long-term fundamental impact of these events is limited, they do have a very real impact on the bitcoin market – at least in short-term. China banning their institutions from offering Bitcoin services and actively censoring exchanges mean that Chinese investors will have a higher threshold to participate in the market. Another appropriate concern is that these actions could set an example for other governments to take similar actions.
One thing is quite clear though: the number of entities that are (on-chain) active on Bitcoin have declined a lot after the recent turn of events. This number was already mildly trending down since the January local top, but dropped dramatically after these events and is now back to levels not seen since briefly after the March 2020 market crash (figure 6).
Figure 6: The weekly number of entities that are active on-chain.
Image source
It is likely that fear and anxiety drove out investors with low confidence, but this activity decline could also mean that others are waiting to see how this plays out.
On-chain data suggests that, in reality, we’re likely seeing a combination of both. The first chart to support that thesis is displayed in figure 7. Over the last few months there has been a clear downtrend in “dormancy,” which means that an increasing proportion of the bitcoin being moved on-chain consists of relatively “young” coins; weaker hands are moving their more recently acquired coins. The weekly averaged dormancy per entity on the network is now back to levels not seen since September 2019 – well before the recent bull run started. Longer term holders aren’t selling.
Figure 7: Entity-adjusted (weekly) dormancy.
Image source
Another chart that clearly shows that it is particularly the newer market participants that are in pain right now is shown in figure 8. The Spent Output Profit Ratio (SOPR) is a measure that represents to what extent the average of all coins that moved at a certain time were in profit (above the solid gray line) or at a loss. Figure 8 shows this metric for the bitcoin of short-term holders (STH), which is defined as coins that are less than 155 days old.
Current STH-SOPR levels clearly show that short-term holders are in a lot of pain right now and are moving their coins around on-chain at losses only seen during some of the more painful downturns in Bitcoin history. The main question on everyone’s mind right now is whether the current capitulation will end up like the ones during the bear cycles that followed after reaching a halving cycle blow-off top (red ovals) or more like a mid-cycle market flush (green and orange ovals).
Figure 8: Short Term Holder (STH) Spent Output Profit Ratio (SOPR) over time.
Image source
Figure 9 shows that, overall, bitcoin is being accumulated by long-term holders (recent uptrend in orange line). During strong run-ups towards new all-time highs, these long-term holders tend to sell some of their coins to take profit (temporary declines in orange line). As price runs up, new market participants rush in and start to accumulate bitcoin (increase in blue line), but they either end up selling their coins after the market turns or they turn into long-term holders themselves (decrease in blue line + increase in orange line).
Figure 9: The bitcoin price (black), circulating supply (green), long-term holder supply (orange) and short-term holder supply (blue) over time.
Image source
During the recent market downturn, bitcoin’s liquid supply increased a lot, as some existing holders were scared out of their positions (figure 10). The trend in the daily change of the liquid supply turned around after the May 19, 2020 capitulation event (red area), where bitcoin traded down more than $10,000 within a single day for the first time. Since June 16, the daily change flipped negative again, which means that the liquid supply of bitcoin that is available on the market is now decreasing again (green area), building towards the next potential supply shock. This could be an early sign of sell pressure exhaustion (as we saw before, mostly from short-term holders).
Figure 10: Daily changes in bitcoin liquid supply over time.
Image source
El Salvador Adopts Bitcoin As Legal Tender
On June 5 Jack Mallers and the President of El Salvador, Nayib Bukele, surprised the world with an announcement at the Bitcoin 2021 Conference that El Salvador would make bitcoin legal tender in the country. A few days later the law was approved with a vote of 62 out of 84 congressional votes.
With this historic move, El Salvador became the first country in the world where bitcoin can be used as a legal form of payment. This step means that the about 70% of the country that is unbanked now has a digital payment option. Merchants in the country are required to accept bitcoin, but will be able to instantly swap the received bitcoin for U.S. dollars, the other legal tender in the country. To achieve this, the country will provide an official wallet called Chivo, which runs on the Lightning Network and is based on Jack Mallers’ strike. However, Salvadorans will be free to use any other bitcoin wallet available on the market as well. To further support its adoption, the government of El Salvador will be giving each of their 6.8 million citizens thirty dollars worth of bitcoin upon opening the Chivo wallet.
El Salvador’s bitcoin adoption also means that citizens will have a much cheaper option for remittances, which represented 20.8% of El Salvador’s Gross Domestic Product (GDP) in 2019. The country also sent out its invitations to Bitcoin corporations and individuals that are considering moving to the country due to its now more Bitcoin-friendly tax regime, offering full residence to anyone that spends three BTC in the country. To top things off, El Salvador is incentivizing Bitcoin miners to come to the country, offering them access to 100% carbon-free geothermal energy powered by volcanoes.
An ironic confluence of circumstances meant that while China pushed Bitcoin and its miners away from its country, El Salvador opened its arms to it as far as it could. El Salvador’s move and the worldwide responses to it have triggered politicians in a large number of other countries to publicly advocate for Bitcoin as well. An opposition party in Paraguay has already taken it as far as to announce their plans to introduce a similar law in their country in July.
Since El Salvador’s legal tender law doesn’t fully go into effect until September 7, 2021, its impact on Bitcoin on-chain metrics is likely to gradually come into place over the months leading up to it. While it is too early to draw any firm conclusions at the time of this writing, there are at least some indications that new people are coming onto the network.
Figure 11 shows that over the last few weeks, the net growth of entities on the Bitcoin network has seen a steep rise. Even if this turns out to be completely unrelated to the developments in El Salvador, it is encouraging to see this type of new adoption,especially during a period when price has fallen.
Figure 11: Weekly net growth of entities on the Bitcoin network.
Image source
Another metric that suggests increased Bitcoin adoption is the number of accumulation addresses (figure 12), which are Bitcoin addresses with at least two inputs and no outputs. The clear uptrend that was already present before the El Salvador news suggests that those are unrelated, but will be interesting to follow over the upcoming months as well.
Figure 12: Number of Bitcoin accumulation addresses.
Image source
Another possible sign of adoption by citizens of El Salvador would be to see the supply held by entities with relatively small balances increase – which is exactly what is happening right now for entities holding up to 0.1 BTC (figure 13). Like in figure 12, this uptrend was already present before the news which means that it may be unrelated to the events in El Salvador, but an interesting trend to see during a price decrease nonetheless.
Figure 13: Bitcoin price (black) and supply held by entities holding <0.001 BTC (green), 0.001 to 0.01 (blue) and 0.01 to 0.1 BTC (orange).
Image source
Since El Salvador’s government wallet will run on Lightning and any bitcoin use for day-to-day payments is likely to utilize Lightning as well, it will also be interesting to see what their new law does for Lightning Network adoption. Figure 14 shows that while it is unclear if the recent events in El Salvador changed anything, Lightning Network adoption has been going incredibly well throughout this bull run, as the number of nodes, public channels and total value on the network have been steeply rising.
Figure 14: The number of public lightning nodes (top left), lightning network liquidity dispersion (top right), number of public lightning channels (bottom left) and total BTC value on the lightning network (bottom right).
Image source
The big question on everyone’s minds is whether the current bitcoin bull market is now over, or if we will see a double top like scenario like we saw in 2013.
Bitcoin bulls will look for the El Salvador legislation to go into full effect after the summer, possibly combined with a hash rate recovery and improved miner decentralization if the Chinese miners indeed successfully relocate, to provide a tailwind for a shift to a more bullish market sentiment. Bears, on the other hand, will point out the market craze during Q1 as a clear market mania top, expecting to see bearish sentiment prevail from here on out.
Figure 15 shows the results of a bitcoin market sentiment poll taken on Twitter on June 30, 2021. As can be seen, respondents are leaning bullish on all timeframes – especially the longer ones. Polls like this are unscientific and rife with selection bias and need to be taken with a grain of salt, but these results at least illustrate that there is still hope amongst a certain segment of Bitcoin Twitter that prices may go back up again throughout the upcoming period.
Figure 15: Bitcoin market sentiment based on a one-day Twitter poll ending on June 30th, 2021.
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We like to close off this monthly column with the “Bitcoin Halving Cycle Roadmap” that combines several popular prediction models that are based on time, the Stock-to-Flow models, cycle indexes and the Bitcoin Price Temperature (figure 16). Will this be the most underwhelming halving cycle in Bitcoin’s existence (and thus basically the end of several of these models), or are we still in for a treat later?
Figure 16: The Bitcoin Halving Cycle Roadmap.
Previous editions of Cycling On-Chain:
Disclaimer: This article was written for educational, informational and entertainment purposes only and should not be taken as investment advice.
This is a guest post by Dilution-proof. Opinions expressed are entirely their own and do not necessarily reflect those of BTC, Inc. or Bitcoin Magazine.
Cycling On-Chain #1: Unwinding Leverage
Dilution-proof, June 1, 2021
Cycling On-Chain is a monthly series that uses on-chain and price-related data to estimate where we are in bitcoin’s market cycle. It originally started as a monthly Twitter thread that was later adopted by Bitcoin Magazine. In this first edition of Cycling On-Chain, we’ll look back at the first leg up in the 2020–2021 bull run and the circumstances that turned out to be fertile soil for a firm downward correction that brought fear into the market. The second part will attempt to look forward by building a case for why we may not have seen the top of this market cycle, as well as some of its vulnerabilities.
The January Turnaround
Just like the previous two versions, 2020’s halving created a supply shock that triggered an exponential price increase. However, in comparison to the previous (2016) halving cycle, this cycle heated up much faster (figure 1).
Figure 1: The Bitcoin Price Temperature Bands per halving cycle
As you would expect during such a rapid price increase, market participants started taking profits when the bitcoin price broke its all-time high in December 2020 and the period after (figure 2). Since forming a local market top in January 2021, profit taking decreased — despite the price still grinding up further during that period.
Figure 2: A seven-day moving average of the Entity-Adjusted Spent Output Profit Ratio (SOPR)
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What usually happens during these exponential price increases (figure 3), is that long-term bitcoin holders (green) start to gradually sell, while new market participants (purple) start building their positions — until the market cycle reaches a top and both parties switch roles.
Figure 3: The bitcoin price (black) and the total (blue), long-term holder (green) and short-term holder supply (pink)
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If we zoom in on the net position change of the long-term bitcoin holders (figure 4), we see that long-term holders were mostly selling up to the January 2021 local top, slowed down their spending afterward and have turned into net accumulators during this price dip.
Figure 4: Bitcoin price (black) and long-term holder supply change (green and red)
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A similar trend can be witnessed in the net position change of miners (figure 5), another class of market participants with clear long-term market experience and exposure.
Figure 5: Bitcoin price (black) and miner net position change (green and red)
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Levering It Up
In March 2020, a large macro-driven price crash cleared the bitcoin market from all leverage and created more organic market conditions that turned out to lay the groundwork for this 2020–2021 bull run. Since then, a clear trend of decreasing bitcoin reserves on exchanges was witnessed, suggesting that a large supply shock was forming. After the bitcoin price broke its 2017 all-time high, this trend has accelerated on pure spot exchanges that don’t offer derivatives trading (figure 6).
Figure 6: Bitcoin reserves on spot exchanges
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However, the opposite is true when looking at exchanges that do offer derivatives products (figure 7). These derivatives exchanges have seen their bitcoin reserves increase, especially after the price started consolidating and correcting.
Figure 7: Bitcoin balances on derivative exchanges
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The bitcoin reserves on derivatives exchanges are (at least partially) held as collateral for (high) leveraged trading. In the months following the January 2021 local top, the amount of open interest on bitcoin futures more than doubled (figure 8), suggesting that market participants were increasingly comfortable taking risks — a possible sign of market euphoria.
Figure 8: Open interest in bitcoin futures on all exchanges (Source)
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As can be seen in figure 9, most of this open interest was representing long positions. When the market is massively (over)leveraged into one direction, there is a clear incentive for large market participants to push the price the other way. When the bitcoin price drops below a long position’s liquidation price, exchanges can force-sell the position, creating even more downward price pressure, potentially forming a cascading effect of long liquidations that is combined with a steep price decline, which is exactly what we saw on May 19, 2021.
Figure 9: Funding rate of perpetual bitcoin futures on all exchanges
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A Change Of Scenery
A change of scenery could be witnessed in several other metrics during the first quarter of 2021. For instance, the bitcoin holdings of the Grayscale Bitcoin Trust that had seen steep increases based on institutional demand stopped rising in February 2021 (figure 10), while the premium on its (GBTC) shares actually turned deeply negative.
Figure 10: The bitcoin price (black) and Grayscale’s holdings (green) and premium over spot-market price (purple)
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During the first quarter of 2021, the anticipation of Coinbase’s direct listing (sometimes referred to as their initial public offering or IPO) was another narrative that a lot of market participants were following. Both the bitcoin price (orange) and COIN price (black and white) were creeping up during the months up to this event, and found their all-time highs around their direct listing date on April 14, 2021 (figure 11). The direct listing was accompanied with large sell pressure from Coinbase executives that were selling part of their positions, creating a steep downward price movement in the price of their shares.
Figure 11: USD price charts for Coinbase (COIN, black and white) and bitcoin (BTC, orange)
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Another clear trend change that occurred after the January 2021 local top was the fast decline in bitcoin dominance that we have seen since then (figure 12). This declining bitcoin dominance means that altcoin price appreciation was outperforming that of bitcoin, which can likely be attributed to retail market participants entering the scene en masse.
Figure 12: Bitcoin dominance (black and white) and price (Orange)
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Young Whales Crashing The Party
Since the January 2021 local top, a clear downward trend can be witnessed in the degree in which older coins are responsible for the on-chain volume (figure 13). This means that recent price movements can increasingly be attributed to relatively young market participants.
Figure 13: A seven-day moving average of the entity-adjusted bitcoin dormancy
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When zooming in on the on-chain movements of the largest players in the bitcoin market (“whales”), it is also clear that most of the on-chain movements were made by young whales. An example of this is visualized in figure 14, where the green circles highlight the (magnitude of) whale addresses that transacted on-chain during the May 19, 2021, capitulation event. These on-chain movements are likely a combination of these young whales (1) triggering the price crash itself, (2) selling out of anxiety, (3) getting liquidated from their long positions and (4) buying back at a lower price for tax benefits (“tax harvesting”).
Figure 14: Outflows from whale wallets on May 19, 2021
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A Mountain Without A Peak
The big question that remains — is this party over now…?
It is impossible to predict the future based on historical data since the context of that data continuously changes and future events can simply take a different course. Nonetheless, comparing current and historical on-chain data structures can be helpful to gauge to what extent (cyclical) investor behavior rhymes in terms of market psychology.
One example of this is illustrated in figure 15. Unlike the previous market cycles, whose tops were all marked by an exponential blow-off top that was combined with long-term holders massively selling into market strength, this cycle (so far) has had neither. Of course, this cycle does not have to be similar to the previous ones, but this does illustrate that it would be quite atypical if the current cycle indeed ends with a dud.
Figure 15: The Reserve Risk indicator
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A New Hope(?)
As just pointed out, we cannot predict the future based on on-chain data; but we can monitor trends in its flows to help us understand recent market movements and more substantially speculate where the market might move next. Despite the steep price drop, some positive on-chain signals could be witnessed.
During the recent market correction, exchanges saw large net inflows of the short-term holders that were getting out of their positions (figure 16). As price declined, so did the net transfer volume from/to exchanges, even turning net negative again near the end of the price dip. This suggests that the lower prices triggered (new?) demand, increasing confidence that buyers will continue to step in during dips.
Figure 16: A seven-day moving average of the net transfer volume of bitcoin from/to exchanges
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During this dip, there also were large outflows in over-the-counter (OTC) trade desks (figure 17). These OTC desks facilitate trading between larger entities that want to buy or sell bitcoin without moving markets.
Figure 17: A seven-day moving average of bitcoin outflows of OTC trade desks
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Another possible sign of continued demand for (spot) exposure to bitcoin is the stablecoin reserves on spot exchanges that have continued to go up (figure 18).
Figure 18: Stablecoin reserves on spot exchanges
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Based on the number of accumulation addresses recently peaking to new all-time highs, the price dip also appears to have triggered market participants to dollar-cost average (DCA) into a bitcoin position (figure 19).
Figure 19: Number of bitcoin accumulation addresses
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Finally, the recent spike in the net growth of entities on the Bitcoin network suggests that during the price crash more entities joined than left, also suggesting that the lower prices enticed some people to buy into a position (figure 20).
Figure 20: A seven-day moving average of the net growth of entities on the Bitcoin network
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Although Twitter polls always need to be taken with a grain of salt, the results of the poll displayed in figure 21 provide another signal that market participants still have a positive mid- to long-term expectation for the bitcoin price. Respondents are neutral to mildly bullish on a weekly to monthly time frame but clearly still very bullish on a yearly time frame.
Figure 21: Bitcoin market sentiment based on a May 31, 2021, Twitter poll
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Taproot
Besides price-related interest in bitcoin’s prospects, prospects about Bitcoin’s Taproot protocol upgrade may provide a more fundamental driver for enthusiasm throughout the remainder of 2021. Taproot improves some of Bitcoin’s on-chain privacy characteristics and unlocks new possibilities for scaling, smart contracts and Lightning. The protocol upgrade is expected to be locked into activation within the next two weeks and will be activated in November 2021 if successful.
Figure 22: The status of the miner signaling process for the Taproot Bitcoin protocol update on June 1, 2021
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A Note Of Caution
The recent unwinding of leverage and change of scenery provided a call for caution, as well as a warning that the bitcoin market has reached a very volatile and vulnerable phase, regardless of the direction in which it moves next.
During the past year, bitcoin has matured into a macro-asset that is increasingly adopted by institutional investors, moving the asset into a whole new playing field. It may, therefore, see regulatory headwinds that can spur anxiety into markets, even if those narratives are based on flawed information.
Another possible result of the increased institutional adoption is that its price developments may increasingly start following those of the larger overall macro cycle. Like we saw in March 2020, its price course may be impacted if a macro-economic breakdown were to happen.
A Possible Outlook For 2021
There are no guarantees that the bitcoin price will necessarily mimic the trajectories of its previous (halving) cycles. Nonetheless, models like the S2F and S2FX, time-based models or more simple previous cycle indexes that are displayed in figure 23 may be useful for getting a rough idea of what may be ahead if bitcoin’s four-year cycle indeed rhymes at least one more time.
Figure 23: Bitcoin halving cycle roadmap (2020–2024)
Disclaimer: This article was written for educational, informational and entertainment purposes only and should not be taken as investment advice.
This is a guest post by Dilution-proof. Opinions expressed are entirely their own and do not necessarily reflect those of BTC, Inc. or Bitcoin Magazine.