Analyzing cryptocurrency markets may seem easier than traditional markets because blockchain technology has more built-in transparency, enabling anyone to analyze and audit on-chain data.
Simultaneously, however, there are challenges to zeroing in on forward-looking numbers that give insights into current and future price trends. Philip Gradwell, chief economist at the blockchain intelligence firm Chainalysis, joined CoinDesk earlier this week to discuss the five must-track on-chain indicators for all traders.
"The first indicator that I look at every day is exchange inflows," Gradwell said.
Investors typically transfer coins from their wallets to exchanges when they want to liquidate their holdings and take direct custody of their holdings when they have a bullish view on the cryptocurrency.
A surge in inflows in a rising market could be considered a sign investors lack confidence in the uptrend. "When you see large inflows, it's time to be cautious," Gradwell added.
Nonetheless, inflows do not imply immediate liquidation. Investors can hold their coins on exchanges for as much time as they want.
"Historically coins have been liquidated with a lag of 12 to 36 hours," Gradwell said, adding that during the March crash there was panic selling.
Thus, this indicator is just one piece of the puzzle because we don’t know when the transferred coins will be sold. What’s more an uptick in inflows or selling pressure is often matched by an equal or more substantial buying pressure.
To determine the impact of exchange inflows on the supply side, investors should keep an eye on the demand side with the help of the "trade intensity" metric, which measures the number of times an inflowing coin is traded.
"It tells us how many people are willing to buy bitcoins sent to exchanges," Gradwell said. An uptick in trade intensity shows that buyers are outweighing sellers and it is a sign of trend strength.
Bitcoin jumped over 7% to 15-month highs above $12,300 on Wednesday. Amid the price rally, cryptocurrency exchanges tracked by blockchain intelligence firm Chainalysis received a total of 106,519 BTC on Wednesday, the highest daily inflow since Oct. 2.
However, the rise in inflows failed to apply the brakes to the price rally because demand was strong. Bitcoin's trade intensity jumped to a two-month high of 5.8, more than double the 90-day average.
While exchange inflows and trade intensity help gauge short-term market conditions, the remaining three indicators are more about long-term trends.
Investors can buy cryptocurrencies with fiat currencies like the U.S. dollar or use dollar-backed stablecoins like tether to fund purchases.
Crypto-to-fiat exchanges facilitate the exchange of dollars for cryptocurrencies, while at crypto-to-crypto exchanges stablecoins are used as a gateway to crypto trading.
Investors can determine whether the market is driven by fiat buyers (such as institutions) or tether traders by keeping track of net flows between these two types of exchanges.
Net flow from crypto-to-fiat exchanges to crypto-to-crypto exchanges suggests the market is dominated by stablecoin traders. In this scenario, a rise in the stablecoin's issuance could be considered a leading indicator of an impending price rally.
However, that, too, isn’t set in stone. Since March, crypto-to-fiat exchanges have received 206,000 BTC from crypto-to-crypto exchanges, according to Chainalysis. "It indicates that fiat buyers have mainly driven the market," Gradwell noted, adding that the data confirms the bullish narrative of rising institutional participation in the top cryptocurrency.
Investors can gauge the hodling sentiment in the market by keeping track of the number of liquid and illiquid entities – clusters of addresses controlled by the same participants in a network. Chainalysis identifies entities by analyzing blockchain transaction patterns to identify which addresses are controlled by a single person or business. This gives a more accurate picture of what is going on as the data better reflects actual holdings and transfers between people and business, reducing the noise of internal movements of cryptocurrency.
Liquidity is the average ratio of net to gross flows of an entity’s assets over the entity's lifetime, across all addresses controlled by the entity. Chainalysis defines a liquid entity as the one that sends on average at least 25% of the assets it receives, while an illiquid entity is the one that sends on less than 25% of its received assets.
Essentially, an illiquid entity is the one that appears to believe in the cryptocurrency's long-term prospects and hoards coins. That has a weakening effect on selling pressure in the market. For that reason, a sustained rise in the number of illiquid entities is a sign of strong hodling sentiment and a bullish indicator.
The above chart shows the liquidity of bitcoin has declined to the lowest level since mid-2017. Bitcoin's meteoric rise from $5,000 to $20,000 that happened in the final quarter of that year.
Also, the amount of illiquid bitcoin has risen sharply. "It's been increasing at a greater rate this year than it did before. So you've got more investors than ever before. But there's also fewer bitcoin that are liquid and available to buy than ever before," Gradwell said.
That possibly the reason why bitcoin recently held steady above $10,000 despite the BitMEX indictments, KuCoin hack, OKEx private key drama, U.S. President Donald Trump's health scare and a global stock market sell-off.
Value transfers across blockchains
Value transfer refers to the U.S. dollar value of total units on a blockchain that are transferred on a given day. It essentially represents the usage of the blockchain and is accompanied by a rise in the transaction count.
"When there's greater usage of a cryptocurrency there's more demand, and that drives the price up," Gradwell said.
Ether's value transfer began rising sharply in mid-July. A week later, the cryptocurrency picked up a strong bid around $250 and ended up rallying to $470 by mid-August. Ether led the broader market higher in July and August and outshined bitcoin by rallying 53% and 26%, respectively.
Up until last year, bitcoin pretty much led the broader market in both bull and bear runs. Most investors would buy ether and other alternative cryptocurrencies during bitcoin's bull run and sell those other cryptocurrencies when bitcoin was on the downturn.
However, the dynamics have changed this year with the explosive growth of the Ethereum-based decentralized finance protocols, making it imperative for investors to track on-chain activity of ether and other coins.
As crypto markets continue to grow and mature, demand for deeper on-chain analytics is likely to increase. “With on-chain data, there is an amount of work that needs to be done first, to go from raw blockchain concepts like an address to a more meaningful economic concept like the flow into an exchange. But once it's done, the user has a meaningful data set to act on and make decisions,” Gradwell said.
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