With bitcoin stuck around $30,000 and watchers trying to figure out its new direction, two popular ways of gauging trading sentiment – bitcoin’s exchange balance and the percentage of inactive supply – have suddenly become less reliable. Onchain is a proxy term for network data that can be easily read because blockchains are inherently transparent.
What is the reason for this change? It has to do with the emergence of new products like exchange-traded funds (ETFs), exchange-traded notes (ETFs), and corporate buyers over OTC desks.
Before going into details, let’s first look at how traders have drawn conclusions from the two indicators from the past.
Bitcoin’s exchange balance, also known as exchange reserve, refers to the total number of coins held in wallets tied to cryptocurrency exchanges. Market participants typically move coins from their wallets to exchanges when intending to sell. Therefore, a rising exchange balance is taken to represent an increase in the number of coins available for sale (i.e. supply pressure) and bearish sentiment. On the other hand, participants take direct custody of coins when intending to hold them long-term. Thus a declining exchange balance represents fewer coins available for sale and bullish market sentiment.
Bitcoin’s inactive supply refers to the percentage of circulating supply that has not moved for a specific period. Again, a rising inactive supply indicates accumulation, while a declining trend suggests otherwise. Historically, phases of accumulation, represented by a sustained uptick in the inactive supply, paved the way for solid price rallies. Meanwhile, tops and bottoms on exchange balance have coincided with major bullish and bearish trend reversals in bitcoin.
However, these indicators now appear less reliable as they overlook the impact of fast-growing bitcoin-linked trading vehicles like tokenized bitcoin, ETFs, ETPs and bitcoin trusts. “Coins are moved into some structure outside of exchange balances and held over time. But they are easily available to trade, and trading activity in these vehicles impacts the market due to arbitrage and market efficiencies,” Arcane Research’s Vetle Lunde told Forbes.
Essentially, coins ending up in the alternative vehicles are still liquid or active, even if they don’t appear to be by the metrics mentioned above.
For instance, assume a trader named Alice has been holding 100 BTC in cold storage since 2017. At the onset of the bull market in late 2020, Alice decided to convert her BTC to Wrapped Bitcoin or WBTC – an ERC-20 token representing bitcoin – to earn extra returns through lending/borrowing and yield farming in decentralized finance. One WBTC equals one BTC.
According to onchain indicators, Alice’s 100 BTC left exchanges in 2017 and have remained idle for four years, a sign of a holding mentality. However, that’s not the case. The 100 BTC became active or liquid (albeit on Ethereum) after Alice tokenized her holdings and could have influenced the spot market depending on its use in the DeFi space.
WBTC is deeply involved in the world of Ethereum wallets, decentralized applications, and smart contracts. At the time of writing, there are 276,503 BTC in circulation. Its market capitalization has increased from $8 million to $8 billion in two years, having hit a high of $16 billion in November last year, per data source CoinMarketCap.
It’s the same story with ETPs, which allow investors to take exposure to or trade bitcoin without having to own the cryptocurrency. The issuer pools the cryptocurrency with the help of an authorized participant and moves it to custody while ETP investors express their views by purchasing or selling units on a stock exchange, representing a proportional interest in the bitcoin held in custody. Again, pure on-chain metrics would tell you that the bitcoin remains idle, but there is clearly market activity taking place. An authorized participant, a specialist, a market maker, or a large financial institution acquires the securities that the ETF wants to hold in return for a block of equally valued ETF shares, called a creation unit.
Additionally, market-making/arbitrage activities in these alternative markets affect the spot price. Authorized participants (AP) are tasked to keep the ETF’s market price closely aligned with the value of the assets held in custody. If the ETF trades at a premium, the AP can buy coins and sell the ETF on the open market. On the other hand, if the ETF trades at a discount, the AP can purchase ETF shares on the cheap and redeem them for the underlying, which can be sold. Onchain metrics overlook the impact of the arbitrage process.
“Arbitrage is the hidden force leading financialized and tokenized bitcoin to be relevant in assessing bitcoin’s liquid circulating supply. A huge deviation in the WBTCUSDC [Wrapped Bitcoin-stablecoin USDC pair] price after an imagined huge buy order in WBTC will lead market makers to respond, having spill-over effects on BTC’s price,” Arcane’s Lunde noted in the blog post published last month.
Tokenized bitcoin and other alternative investment vehicles like ETFs, ETPs, Grayscale’s bitcoin trust, and corporate balance sheets have accumulated more than 1 million BTC in the past two years, representing nearly 6% of bitcoin’s circulating supply of 18.92 million, according to data provided by Arcane Research. Shares in the Grayscale bitcoin trust traded at a record discount of 31% to the underlying spot price early this month. The shares fell into a discount in February 2021 due to several reasons, including the launch of a spot-based ETF in Canada. The ETF listing provided an alternative to institutions looking to take exposure to bitcoin via a stock market vehicle. The US Securities and Exchange Commission approved several futures-based bitcoin ETFs last year. Meanwhile, several physical bitcoin ETFs have begun trading and gained traction across Europe and in Canada over the last two years. Per Bloomberg, a US-based spot bitcoin ETF, if approved, would attract trillions of dollars.
Per Arcane Research’s estimates, the amount of liquid tradeable bitcoin supply sits closer to 3.9 million BTC if we adjust the exchange balance for the BTC accumulated by alternative vehicles. That’s 62% greater than 2.4 million BTC found by exploring exchange balances.
Lastly, bitcoin’s price discovery is also impacted by the cash-settled futures listed on the Chicago Mercantile Exchange (CME), as detailed in Bitwise’s lead-lag analysis of the bitcoin market. Historically, open interest or the dollar value locked in the CME-based futures contracts has led major trend reversals in bitcoin’s price. The CME futures market, considered a proxy for institutional activity, has an exchange balance of 0 BTC.
Bitcoin’s previous bull market ended following the launch of the CME futures in mid-December 2017. The futures opened doors for bears or non-believers to express their views in a market, which until then, was dominated by believers. According to Christopher Giancarlo, who left the U.S. Commodity Futures Trading Commission (CFTC) in April 2019, the Trump administration pricked the bitcoin bubble of 2017 by allowing the launch of futures products.
“Bitcoin held by centralized exchanges continues to reach multi-month lows, and now sits around 2.5 million bitcoin, or 13.12% of the total supply. Just over 65% of the Bitcoin supply has not moved on-chain in the past year, but these coins may be liquid in other ways. However, Bitcoin is increasingly being held in other areas, such as ETFs, ETPs, or balance sheets, with some estimates accounting for an additional 7% of the circulating supply through these vehicles,” Josh Olszewicz, Head of Research at Valkyrie Investments, told Forbes.
“As these new products grow, they will very likely have a bigger influence on Bitcoin price than traditional crypto-native exchanges,” Olszewicz added.
Bitcoin Recently Crashed Even As Onchain Indicators Painted Bullish Picture
The onchain indicators seem to have lost their predictive powers in the past seven months. Bitcoin’s exchange balance has dropped by 6% to 2.49 million BTC since November, according to data provided by South Korea-based blockchain analytics firm CryptoQuant. The percentage of supply inactive for at least a year has increased from 53.5% to 65% since November. Even so, bitcoin’s price has more than halved to $30,000.
Perhaps these indicators failed to consider the selling pressure from alternative investment vehicles and the CME futures. “This phenomenon is referred to as alpha decay, or signals which were once valuable no longer having the same impact as they did previously,” Valkyrie’s Olszewicz said.
According to Olszewicz, the recent selling pressure came from the Luna Foundation Guard (LFG) deploying its bitcoin reserve to avoid the de-pegging of its algorithmic stablecoin TerraUSD (UST) and from crypto traders, equities traders, or institutional investors who need additional collateral to prevent margin calls for trades going against them throughout the market volatility over the past month.
The LFG, the Singapore-based non-profit organization tasked with defending UST’s peg, accumulated 80,394 BTC early this year. The reserve was emptied over a 21-hour window between May 9 and May 10, with the foundation loaning out coins to over-the-counter firms and market makers to help stabilize the peg. Drilling down further, Glassnode found that 52,189 BTC were sent to Gemini via over-the-counter desks, which were then deployed elsewhere, including Binance, and 28,205 BTC were transferred to Binance directly. The LFG has since confirmed that all of BTC was sold and now they hold just 313 BTC.
Bitcoin’s 17.3% slide in April may have resulted, at least in part, from ETFs and ETPs and close-ended funds listed across Europe and America selling nearly 15,000 BTC (worth $439 million at the going market price).
Alexander Blum, a Managing Partner at Two Prime, a digital assets fund, said, “increasing institutional products like futures’ ETFs likely play some role in the increasing lack of correlation between bullish on-chain metrics and price action.”
“Additionally, a growth of OTC venues and institutional dark pools means that more trading activity occurs in venues off an exchange, while not necessarily indicating HODL sentiment,” Blum added.
Onchain Analysis Is Still Relevant
While pure onchain studies appear unreliable as standalone indicators, many traders and fund managers read them in conjunction with other indicators to gauge broader market trends.
“At Two Prime, we do follow on-chain metrics, like exchange balance and inactive supply, closely as one layer of our data-driven trading algorithm,” said in a Twitter chat. “However, the fast-changing infrastructure and market landscape require regular re-evaluation of what this data indicates. Tracking changes to the utility of various indicators is often more useful than individual snapshots of the data itself.”
Raghu Yarlagadda, Co-founder and CEO of FalconX, one of the largest and fastest-growing digital asset brokerages, said, “the onchain analysis is still very relevant – it’s like if Apple were to report its quarterly earnings, however, instead of waiting 90 days to receive this information, you get it in real-time.”
“No matter if BTC exchange balances rise or fall, they are good for general long-term macro trends, similar to the Consumer Price Index or the Fed Funds Rate. Just as these balances paint a long-term picture of the trends shaping the market as a whole, crypto has its own version of macroeconomics analysis that gives institutional investors an accurate view of what’s happening over time,” Yarlagadda added in an email.
Indeed, keeping a close eye on the inflow of coins into exchanges early this month would have helped investors prepare for the price crash.
More than 53,000 BTC made their way into exchanges on May 9, the highest single-day net inflow since November 2017, according to data provided by Glassnode. The big chunk of the inflow perhaps came from the Luna Foundation Guard deploying its bitcoin reserves to defend UST, as noted earlier.
Two days later, bitcoin crashed to $25,338, the lowest since late 2020. The stablecoin crashed to $0.047 and the liquidation of bitcoin reserve ended up adding to the market panic.
“The biggest seller over the past month has been the Luna Foundation Guard (LFG), allegedly selling 80,000 Bitcoin in their reserves as an attempt to shore up the UST peg. LFG’s large sale is also what has shown up in the on-chain data as a spike in Bitcoin deposits to exchanges over the same period,” Valkyrie’s Olszewicz said.
Speaking of other indicators, derivatives market metrics like options skew, which measures the cost of puts relative to calls, funding rates or cost of holding long/short positions in the perpetual futures market have become more popular. These metrics help understand sentiment among sophisticated traders and their market positioning. Lastly, central banks hell bent on sucking out liquidity from the economy to control inflation, the monthly inflation figures out of the US and other major economies, periodic rate decisions by the Federal Reserve and bond market action have become more important than ever.