There are many different ways to analyse and understand crypto markets. On-chain analysis can be used to both understand a network’s fundamental health and provide some unique insights for potential investment opportunities over different time horizons.
On-chain data in 2022 provided an interesting picture and offered a deeper understanding of the bear market that we sat through and hope for the future.
What is On-Chain Data?
On-chain data is simply the record of all transactions that have occurred on a specific blockchain network. The data itself can be broadly categorised into three separate classes:
Block data – examples include miner fees and rewards or timestamps
Transaction data – examples include transactions between addresses or the value of tokens sent
Smart contract code – any smart contract running on a blockchain
This data can provide insights that generally haven’t been replicable in the traditional world, and this is due to the open nature of public blockchains. Through the process of on-chain analysis, one can understand and analyse an asset in more depth than ever before.
ARK Invest has proposed a three-layer pyramid that represents the depth of analysis you can employ for on-chain data.
Source: ARK Investment Management LLC
There are many different metrics one could look at when conducting on-chain analysis. We have handpicked a few of them and will analyse several different metrics to get a better picture of how 2022 went. The main focus of the analysis will be on Ethereum and Bitcoin, as they represent the two most significant assets in the industry. We are also looking for longer-term trends, so for the purpose of this article, we will focus on the bottom two layers.
At the bottom of the triangle is the general health of the network; this serves as the base and shows if the network is operating as it should.
For Proof of Work (PoW) networks such as Bitcoin, the hash rate represents the level of security. A higher hash rate means more miners are contributing hash power to the network and, therefore, the more secure it is.
Over 2022, Bitcoin’s hash rate went from 175m TH/s to 247m TH/s, an increase of 41%. To put this number in perspective, bitcoin miners worldwide are trying 247 quintillion hashes every second to earn the right to add a block to the chain and earn a block reward.
The increasing hash rate also shows growing confidence in the network and how people are putting financial capital at risk in order to mine it.
Active addresses also provide a good proxy for the health of the network. This metric can be volatile and generally experiences significant increases when markets start making or reaching previous highs. However, what we look for is a consistent increase over time, making higher highs and higher lows.
Over the course of 2022, both Bitcoin and Ethereum experienced a decrease in active addresses. This can generally be expected in a bear market as fewer people actively trade or use the technology. It is, therefore, appropriate to zoom out slightly and see where it is when compared to previous cycles.
Ethereum and Bitcoin have increased and maintained their active addresses compared to the 2017 bull market, which is a positive sign that there has been consistent growth.
Also, remember that these are two of the “slowest” growing networks, as they have been around for a long time and have the most active users. We have seen significant growth on newer layer 1’s, such as Near, and layer 2’s, such as Optimism and Arbitrum.
In 2022 Ethereum made the successful transition from a PoW to a Proof of Stake (PoS) network. Instead of securing itself with hash power and miners, it now secures itself with financial collateral in the form of ETH and validators.
Therefore watching the number of active validators can give us an idea of whether the network is becoming more or less secure.
In 2022 the number of active validators went from 274 000 to 491 000, a 79% increase. This is also occurring during a period where you cannot withdraw ETH that is being used to validate the network (this will only be possible after the Shanghai upgrade planned for this year happens). This also signals to us that there is growing confidence in the network.
The Lightning Network is currently one of the most viable ways of meaningfully scaling Bitcoin. It will enable low-cost microtransactions to be processed and provide new usability to BTC that we currently lack.
You can look at several metrics to understand where the Lightning Network currently stands; the two most important are capacity and number of nodes.
In 2022 the network’s capacity increased, which means there is more liquidity available, and the network becomes capable of sending higher volume and value of payments. When a node joins the network, they are required to provide liquidity in order to use it; the liquidity they provide represents their total individual capacity.
The number of nodes actually decreased in 2022, which isn’t a positive sign. We would expect this to go up over time; nevertheless, it allows us to infer that each node is supplying more liquidity on average.
Value Locked in DeFi
The Total Value Locked (TVL) in DeFi protocols on Ethereum peaked in November 2021 with the rest of the market. The TVL continued to decrease throughout 2022; it is directly related to price, so this is to be expected.
Something to come out of 2022 is exciting new perpetual protocols that benefit from the speed of Ethereum layer 2’s. So we expect the trend to continue as people further leverage non-custodial on-chain financial tools.
Buyer and Seller Behaviour
Buyer and seller behaviour gives us a better idea of who is holding and selling and at what price. Due to the open ledger, we can see when coins were last moved or transferred, which can help with longer-term decision-making.
Net Unrealised Profit and Loss
Net Unrealised Profit and Loss (NUPL) has historically provided profitable medium and long-term entry and exit points. It allows us to understand how much of Bitcoin’s circulating supply is in profit or loss at a specific moment in time. NUPL helps answer the following question: if holders sold all their bitcoin today, how much would they stand to gain or lose?
NUPL has been in a capitulation phase five times in its history, with the current being one of the longest-lasting. It provides a good understanding of how in the money everyone is; however, to get a better idea of if sellers can continue selling, we can look at a metric created by ARK Invest.
Seller Exhaustion Constant
ARK Invest first proposed this metric as a way to monitor when market volatility is low, and losses are high. This is done by calculating the product of the Percentage Supply in Profit and the 30-day price volatility.
This indicator oscillates regularly; however, it has only touched extremes a few times in its existence. The last was in the 2018 bear market. This indicates that sellers are getting stretched and may struggle to continue selling, yet it still isn’t the lowest we have ever seen, so more selling is possible.
While each halving reduces miners selling power, they are still critical to monitor. Mining as a business operates at a long-term equilibrium where the marginal cost of mining is equal to the market value of the bitcoin mined. However, there can be extended periods where miners, on average, can experience profitable and unprofitable conditions.
A great way to monitor changes in miner profitability is by using the Puell Multiple. The Puell Multiple tracks daily bitcoin issuance in dollars verse a 365-day moving average. Significant deviations from the norm often signal that a change in profitability is approaching. When mining is highly unprofitable, the weak and inefficient miners capitulate, whilst strong miners become exceedingly profitable. When mining is highly profitable, more computational power enters the system to compete over the daily fixed issuance; weak and inefficient miners survive but become susceptible to price changes.
The above chart shows that there has been a slow increase in the profitability of mining, reaching a bottom in June 2022. The above is positive and means that there is positive momentum behind miners, and they may start to become more profitable again.
Not all metrics that are valuable can be from on-chain sources. There are several others, but when it comes to blockchain, one of the most important is the number of developers actively working on a project.
The reason active developers are so important is quite intuitive; without them, blockchains can’t improve or evolve. Through 2022 the number of developers working on their respective blockchains remained relatively steady; it is impressive considering the market conditions.
Ethereum still leads when it comes to the number of developers working on the project. Cosmos, Polkadot and Cardano all ended the year with a similar number of active developers, with Cosmos seeing the most significant increase.
On-chain metrics can provide us, as investors, critical insight into what is happening in the markets at any point in time. It combines old and new analysis with the benefits of an open ledger to create a powerful tool for understanding market dynamics and the networks’ health.
While it is still an emerging discipline, and we have a long way to go before perfecting it, it offers many opportunities that the traditional world doesn’t and there lies its edge.
Open networks are going to change the world, and we look forward to what 2023 has in store for the crypto industry.
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This is not financial advice. All opinions expressed here are our own. We encourage investors to do their own research before making any investments.