Bitcoin On-Chain Analysis

(Check out my online Masterclass on this topic Sunday 19 May at 1400EDT/1800UTC at this link)

So recently you have probably have seen my prolific Discord posts of bizzare chart combinations and drawing strange conclusions based off ‘on-chain analysis’. Today I want to give a quick snapshot of what on-chain analysis is and why I believe the signals we can interpret from it is an excellent tool to help us find edge in the cryptocurrency market.

Uncensorable Transparency

Bitcoin is many things. In my opinion, the most fascinating interpretation is that Bitcoin is the first digital organism. Let me start with a great quote from Ralph Merkle (creator of the Merkle tree data structure) about Bitcoin.

 

“Bitcoin is the first example of a new form of life. It lives and breathes on the internet. It lives because it can pay people to keep it alive. It lives because it performs a useful service that people will pay it to perform. It lives because anyone, anywhere, can run a copy of its code. It lives because all the running copies are constantly talking to each other. It lives because if any one copy is corrupted it is discarded, quickly and without any fuss or muss. It lives because it is radically transparent: anyone can see its code and see exactly what it does.” – Ralph Merkle

 

Bitcoin introduced a new paragdim – Uncensorable Transparency. Every single action that occurs on-chain is recorded by every single node on the network and encrypted by the the most secure network on earth. The degree of data redundancy in the Bitcoin network is unparalleled and finality of events is arguably the first guaranteed source of truth in we have ever had.

On-chain analysis

Now given that the Bitcoin network is so transparent, we can observe all transactions which occur on the network and begin to analyse the fluctuations and temporal trends which arise over time. This gives rise to On-chain analysis which is the study of these patterns to identify trends, correlations and potentially investing signals based on fundamental behavior of the network. This is the first asset where Fundamental Analysis has charts that can be analysed in a similar manner to Technical analysis.

 

Now first step is we need to define the difference between Intrinsic data and extrinsic data.

 

Intrinsic data is information contained within the Bitcoin UTXO set. It includes data such as transaction timestamp in block time, transacted volume in BTC, addresses involved in the transaction, fees paid, Bitcoin hashrate, hashrate difficulty and coin supply.

 

Extrinsic data is information which is not native to the UTXO set which we mere mortals assign to Bitcoin. This includes calender date:time since block time is actually variable with hashrate and not exactly 10mins, Coin price and network valuation. Bitcoin has no idea what day of the week it is nor what the last traded price was, it just knows the block height and who owns how much at that time. It is important to note that all trading volume which occurs on exchanges is NOT seen by Bitcoin as this all occurs internal on the exchange, not on-chain.

 

On-chain analysis combines these two datasets and connects them via human date:time and Bitcoin block time (as best as possible). This creates a bridge between extrinsic data including price to the intrinsic UTXO data set. Now we can start looking for patterns and correlations such as whether price is correlated to hashrate, transaction volume or even the fees paid to miners.

 

What we are looking for here is patterns which repeat over time or indicate macro shifts in network behaviour. The most powerful observations are those which identify shifts in intrinsic data trend (akin to a change in actual network utilisation) to the network valuation (price and market cap).

 

An example of this is when lots of people are sending transactions and making use of the network, the demand should increase and thus coin price should increase in theory. Conversely, if the market has a high valuation but low on-chain transaction, the network is likely overvalued and is likely to correct. This has so far shown to be true and is exactly what the NVT ratio captures (discussed below).

Overview of on-chain metrics

In the coming weeks/months, I will be rolling out the On-chain Masterclass so will explore these concepts in great detail. For now, I will summarise a couple of the key observations and analysis metrics which you may find useful.

 

I guarantee that 99.99% of the market ONLY looks at price and market cap of Bitcoin. If you start to incorporate on-chain analysis into your strategy you will find edge when looking for macro shifts in market behavior. You don’t need to watch on-chain data as frequently because it is most useful when looking for market tops and bottoms. What I will say is that this is one of the best tools out there to help you buy the bottom and sell the top in the next cycle.

Market Cap – This is just coin price multiplied by circulating coins. It is a concept borrowed from equities and is affected by speculation, emotion and exchange traded volume. It is highly volatile and is the ONLY metric most people look at…this is a good metric to compare the speculative value (market cap) to actual utility value (realised cap, transaction volume etc)

 

Realised Cap – This is a measure of the average cost basis of the entire market and the Wealth stored in Bitcoin. It takes every coin and multiplies it by the price when it last moved. Therefore it estimates the price that all ‘Hodlers’ and whales paid for their coins. If the Market cap is above the Realised Cap, the market is on average in profit. Converely, when market cap falls below realized cap, it is a sign of capitulation and the market being underwater and has so far been the buying opportunity of the decade.

Figure 1 – Market Cap (green) vs Realised Cap (yellow) and coin supply (blue). Note how Realised Cap is a smoother stair stepping pattern and when market cap falls below it it signals a buying opportunity

 

NVT ratio – This is the Market Cap divided by Transaction volume on-chain. It represents how much the network is being used (transactions) compared to the network value. If transactions are high, the network has high demand and utility and the NVT is low (< 10 in a bull market). When the NVT increases to more than 18 to 30, it means price is getting too high compared to network utility and may be somewhat overvalued. NVT is the equivalent to the Price-to-Earnings ratio (PE) of equities as the value throughput of Bitcoin.

Figure 2 – The NVT Ratio (yellow) acts like an oscillator where values between 5 and 15 are common in a Bull market and values higher than around 18 are typical of bear markets (high NVT means low transaction volume and high network value = overvalued).

 

Hold Waves show the age of all coins on the Bitcoin network, that is the time since they were last moved. Older coins are usually purchased at a cheaper price by strong hand Hodlers which means when they are on the move in large volumes, it may be indicating profits are being realised. This is represented by the blue colours where the large dark blue area represents coins older than 5yrs and contains the strongest hands, presumably lost coins and even Satoshi’s coins. The important thing to watch for is when the orange and yellow zones grow larger in a short period of time. This may indicate large scale profit taking OR capitulation and could signal market tops or bottoms. You can find the HODL waves at Unchained Capital here.

Where can I find on-chain charts?

At the moment, there are a plethora of research papers out there on these topics for those of you who are interested in reading up further. The majority of these are on Medium so I would suggest following these analysts on medium and Twitter and reading through their blogs and archives (just do one paper at a time, they can be information dense but usually very well written).

Chris Burniskie – Placeholder VC

Will Woo – Woobull Charts

Murad Mahmadov – Adaptive Capital

David Puell – Adaptive Capital

Tuur Demeester – Adamant Capital

Nic Carter – Twitter, Castle Island Ventures and Coinmetrics

Travis Kling at Ikigai – Kana and Katana depot of information

Plan B – Modelling with Scarcity

 

If you are keen to play around with charts and look at on chain data, there are two main tools available for us.

 

The first is Woobull charts http://charts.woobull.com/. These are maintained by Willy Woo and are preselected sets of data which can be very useful in getting a broad picture of what is going on. Willy is often posting about what he sees on Twitter and is worth keeping an eye on. I believe that Willy trades soley based on on-chain data and has a reduced focus on price candlescompared to the average punter.

 

The second location is Coinmetrics who have a charting package that is more customisable and can be used for many different assets https://coinmetrics.io/charts/#assets=btc. You can create your own combination charts, moving averages and ratios using the formulas section (an example is here for the Realised Cap and MVRV ratio). Now possibly the best bit about CoinMetrics is that their data is considered best in class (Woobull uses it also) and can actually be downloaded in CSV format for any coins they support so you can create your own charts in Excel or another plotting interface as you wish.

 

Last Thoughts

I believe that on-chain analysis will be the tool that sets investors apart in the next cycle. It has shown to be incredibly accurate for picking market tops and market bottoms and helps provide buy low and sell high signals for the a long Hodl. I plan to continue delving into these metrics to understand what the data is telling us and will build these out into classes and discussions for our Omnia service.

 

One thing to note is that on-chain analysis CAN be done for almost all coins BUT…right now, only Bitcoin actually has an organic utilisation rate such that meaningful information can be obtained. The reality is most other coins just are not being used for any purpose other than speculation and Bitcoin has the advantage of liquidity, reputation, fiat on-off ramps and coin pairings. This may change in the future for coins that see large scale adoption but for now, this is a Bitcoin only tool. This is an important observation as it shines the spotlight on Bitcoin remaining as the primary asset in this industry with the most organic growth and real utility by investors, Hodlers, speculators and people in need of digital money.

 

If you are keen to understand a topic in more detail, just shout out in the Discord, always happy to work through a problem and see where the data takes us. I plan to release Doc style videos of my on-chain analysis in the future so stay tuned.