Even though decentralized finance (DeFi) is on the right track in terms of growth and adoption, the space is still full of risks, uncertainty and volatility. One of its biggest advantages over centralized finance is the availability and accessibility of financial data. Since transactions are public, blockchain provides a unique opportunity for understanding market sentiment through data analysis.
This innovative prospect is known as on-chain analysis. In simple terms, it is the practice of analyzing the fundamentals, utility and transaction activity of a cryptocurrency and corresponding blockchains in order to predict future price movement and a wider range of market metrics.
Iakov Levin is the founder and CEO of Midas.Investments, a custodial CeDeFi (centralized decentralized finance) crypto-investment platform.
On-chain analysis provides a view of the digital finance system for better decision-making and helps answer critical questions: Who's holding the majority of assets? Are holders of a specific token sitting on profits?
Why do we need an on-chain analysis?
Any form of investment requires an extensive analysis of market sentiment and capital positions. There is always a challenge in traditional business analytics because market data is not always transparent.
On the other hand, the transparent nature of DeFi means there is a lot of accessible data. However, for such data to be actionable it needs to be refined, organized and transformed into comprehensible information.
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The on-chain analysis approach bridges this gap. It creates an effective practice to measure necessary data and metrics and potentially simplify complex investment decisions.
Moreover, it can be a powerful practice in identifying protocols with high liquidity and security risks. We are only in the early stages of on-chain analysis. However, the emergence of more innovative data brokers and analytics solutions could see next-gen chain analysis bring more comprehensive visibility to the entire DeFi industry.
The negative side of on-chain analytics
It’s important to remember that we shouldn’t rely on on-chain analytics alone. More often than not, it doesn’t provide the entire picture of market transactions where we see the skeleton data of transactions without understanding their context. There’s a risk that one may not see the bigger picture regarding what's driving the current market sentiment – and how long it might be sustained.
The crypto and DeFi spaces are highly strategic. Recently, we've seen tweets or announcements from influential public figures significantly pump specific tokens beyond their projected value, and small changes in regulations completely decimate a token's floor price. These prospects are relatively frequent in the DeFi space, which can't be predicted through on-chain analytics.
Focusing too granularly on micro details can cause the broader strategic narrative to be lost. While such analytics effectively provide critical insights into each transaction, they can't provide a broader context by linking each activity across the blockchain.
Still, such pitfalls of on-chain analytics might be addressed in the future when we see more and more wallets being labeled across the exchanges, making it possible to make investment decisions in a much more balanced and efficient way.
How to use on-chain analysis effectively
The most critical on-chain metrics that investors tend to rely on are liquidity indicators and their changes over time. On-chain analytics looks to provide insights into how liquidity spills from one protocol to another over time. For example, if a network is experiencing high liquidity, it can be predicted that some associated protocols and tokens will lose value.
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There are several different analytics tools that are tailored for different levels of investors. The most basic one is Nansen, which allows users to dig deep into what's happening inside wallet addresses across the blockchain. Nansen helps to identify token flows between major players, where money is being moved and deposited, which non-fungible tokens (NFT) are positioned for higher prices, and more.
Then there's Dune Dashboard, where users (usually advanced traders) can write SQL queries to identify and track required metrics and convert them into comprehensive visual charts. There are also other popular tools tailored to specific blockchains, such as Etherscan, Santiment and Messari.
The intense demand for on-chain analysis, and its future
On-chain analysis has become a powerful tool over the last few years, especially for investment firms and venture capital funds. Many have built their own advanced chain analytics systems to identify more in-depth metrics and efficiently manage their clients’ risk positions. Several startups have also entered the blockchain data analytics market, working as data brokers and supplying actionable blockchain analytics data to top venture capitalists (VC) and investors.
The future of on-chain analysis looks promising. This intense demand for on-chain analytics will continue to grow because Web3 services are projected to increase by 700% in the next five years. As more VCs and hedge funds use these analytics for making sustainable decisions and more data brokers enter this space, the current challenges of on-chain analytics will be addressed through innovation.