On-chain analysis (or blockchain analysis) is an emerging field which examines the fundamental factors of cryptocurrencies to improve investment and trading decisions.
The development and application of these ideas are promising for traders who want to leverage public blockchain information, with the potential to enhance their trading strategies and position management.
Perhaps the most dominant form of analysis in cryptocurrency trading is the study of price action, i.e., technical analysis. But utilising the wealth of information provided by public blockchains like Bitcoin and Ethereum can provide a unique perspective that is impossible for traditional assets and can complement other analyses.
What is On-chain Analysis?
Cryptocurrency is the first asset class where investor activity can be extracted from massive data sets through each crypto-asset’s public ledger, which captures every on-chain action in history.
Since blockchains are a treasure trove of open, incorruptible financial data, we can pinpoint measures of economic activity in these networks. Through the collection and study of this data, we can measure sentiment and investor behaviour.
On-chain analysis is a fundamentals driven approach rather than based on hype, sentiment or technical analysis. This type of analysis can be focused exclusively on one crypto-asset by looking at historical trends or can be used to compare different crypto-assets to identify undervalued/overvalued coins.
We can think of the actual value of a cryptocurrency like BTC as made up of two parts: speculative value and utility value. On-chain analysis is a vital tool that helps you separate the speculative value of a cryptocurrency from its utility value. By examining, for instance, user adoption and miner activity using blockchain data, we can see whether the current price is justified by the fundamentals.
A Brief History of On-chain Analysis
On-chain analysis can trace its history back as far as 2011, when coin days destroyed was created as a valuation metric for bitcoin and was the first indicator to make use of the age of bitcoin addresses.
One of the first widely used, on-chain metrics that was developed for cryptocurrencies was the Network Value to Transaction (NVT) ratio, popularised by CoinMetrics, Chris Burniske and Jack Tatar. The NVT ratio was created in summer 2017 to determine the utility value of a cryptocurrency, specifically how much the market is willing to pay for the transactional utility of the blockchain.
By comparing the value of the network with the volume of transactions recorded on the blockchain, we can identify when a cryptocurrency is overvalued. When the value of the network is not justified by the volume of transactions, the NVT ratio is relatively high. When considering the transaction volume, if the network value is unusually low then it may suggest that a higher valuation is justified. The NVT ratio is often compared with the Price-Earnings ratio for equities and is applied in a similar way to find coins to buy, hold or sell.
It wasn’t long until the NVT ratio was iterated upon further. Other researchers made improvements to the metric so it was a more accurate assessment whether the network value is justified by economic activity taking place on the blockchain.
For example, the Network Value to Transaction ratio Signal (or NVTS) was developed by taking the 90-day moving average of transaction volume. More recently, CoinMetrics have refined the ratio further by using the free float supply in their calculations. These gradual improvements demonstrate how the methods of fundamentally valuing a cryptocurrency are continually evolving.
Another on-chain metric emerged from the dissatisfaction with simplistic measures from technical analysis (such as price/volume) and other concepts borrowed from traditional markets, such as market capitalisation. Market capitalisation is widely used by many comparison websites to rank cryptocurrencies.
But since cryptocurrencies are more similar to money or commodities (rather than a company stock), market capitalisation is an inexact and misleading measure. Market capitalisation ranks can be gamed through different methods of issuance — for instance, a token can be created with a circulating supply of 1 trillion and a few coins sold at $1 means the market cap is $1 trillion — but the coin could only have a trading volume of $3.
Because of the weakness with market capitalisation and the pitfalls of applying traditional metrics bluntly to cryptocurrencies, a new set of tools have been developed that can help traders to more accurately and precisely assess the health of blockchain networks.
A lot of these metrics rely on the concept of UTXOs (Unspent Transaction Outputs) in Bitcoin, which can be tracked to see when a wallet last moved their coins or how long an address has held coins for. The age, size and number of UTXOs transferred on a particular blockchain can provide reliable signals and have been developed into on-chain metrics, such as realised capitalisation, HODL waves and percentage of supply in profit/loss.
Realised capitalisation emerged as a way without any of the drawbacks of market capitalisation used to analyse coins fundamentally using blockchain data. Created by Nic Carter and Antoine Le Calvez, realised capitalisation aggregates all UTXOs and each UTXO is assigned a price based on the last time they were moved.
Further work built on the realised capitalisation metric, such as the Market Value to Realised Value (MVRV) ratio which was developed in October 2018 by Mahmud Marov and David Puell. The MVRV ratio can be thought of as an oscillator that has historically respected certain thresholds that suggest bitcoin is over- or under-valued. The metric has been tweaked with variations such as the MVRV z-score, the long-term holder/short-term holder MVRV ratio and application to account-based blockchains like Ethereum as well.
Ethereum as the second largest blockchain network, differs from Bitcoin and some altcoins as it is based on an account model rather than a UTXO model. In the UTXO model, a UTXO calculates a cumulative sum along each coin’s path to a final address, the ledger records who owns what and when, and addresses can have multiple UTXOs.
In contrast, the account model means that individual coins are not as easily tracked since incoming and outgoing coins are mixed into account balances, so some metrics such as coin age for Ethereum and ERC-20 tokens is slightly more difficult to obtain. Some metrics applied to Bitcoin (and other UTXO-based cryptocurrencies like Bitcoin Cash and Litecoin) are not directly applicable to Ethereum or other similar blockchains, and more work is needed to bring these models over to account-based cryptocurrencies.
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