On-chain Analysis

A quick introduction to on-chain analysis using bitcoin blockchain data - what it is, what some of the metrics are and how to interpret them.

In the very long past, people in Japan believed that a giant underground Namazu (catfish) lived right underneath the Japanese islands. This giant catfish was held down and kept still by the god Takemikazuchi. When the god let his guards down, the Namazu moved its fins or its tail causing the ground above it to violently shake. Of course, no catfish lives under Japan. The several tectonic plates that sit under the Japanese islands make it the number one location for earthquakes in the world. But as far as the mythology is concerned, what is clear is this – it is in human nature to try and make sense of the world around us – no matter how complicated or inexplicable things are. The realm of cryptocurrency is one such.

Why do cryptocurrencies have value? How much is an Ether actually worth? What is the age of a bitcoin (from when it is mined)? Who transferred the first bitcoins over to whom? And who in turn did they send it to? A lot of these questions can be answered by using a technique called on-chain analysis.

What is on-chain analysis?

Before we get to that, what is blockchain? Contrary to what you might think, a blockchain is simply a kind of database. Data is stored in the form of blocks and these blocks are ‘chained’ together – and that’s where the innovative name ‘blockchain’ comes from. Most cryptocurrencies use blockchain technology in order to validate and record transactions made. Let’s say Tom sends 10 bitcoins to Harry. One of the ‘nodes’, fancy word for a computer connected to the bitcoin network, validates this transaction. That is, the node checks if Tom indeed has 10 bitcoins in his address, checks to make sure that it really is Tom who is initiating the transaction, and that Harry has a valid address he can receive the bitcoins at. If everything checks out, the node validates the transaction and adds it to a block. A number of other transactions get added to the same block and the block as a whole gets added to the chain. The node that validated the transaction gets a reward (a few coins). That’s why this activity is often called mining.

If every Bitcoin currently in use can be tracked all the way back to when it was first mined and if every single transaction is recorded in the blockchain, you can imagine what a massive treasure trove of information all of this can be. And it indeed is. As of this writing, the entire Bitcoin blockchain data is about 350 Gb – you can store it on your hard disk and run all kinds of analysis on it. And that is called on-chain analysis.

Now, we don’t have to download all of this data to run an analysis on them. Glassnode and The Block are two on-chain intelligence platforms that do this for us. Let’s review some of the interesting metrics to understand how these are being used to make sense of what is going on in the bitcoin world.

On-chain Analysis - Metric 1: Active BTC Addresses

One of the very first metrics that was developed was simply the number of bitcoin addresses created and the number of active addresses. BTC addresses can be thought of as wallets. Here is a look at the latest data.

Bitcoin active addresses went from nothing in 2010 to about 840K! No surprise there. This number has come down from about 1.2M in early April 2021, before the price crash. Here is a closer look at the last 4 years data. You can tell by just visually looking at it that each time BTC’s price crashed, the number of active addresses also went down. Meaning that when the price went down, people ‘HODL’ed it. Read as hold, abbreviated as Hold On for Dear Life, HODL is simply the word hold misspelled.

On-chain Analysis - Metric 2: HODL Waves

Now that you know about HODLers, let’s take a look at HODL waves.

HODL waves represent the age of bitcoins held in wallets. Here is how to think about it – Let’s say you mined 1 BTC 2 weeks ago and left it in your wallet. The age of that coin is 2 weeks. If you spent it 2 weeks later, its age gets reset and it goes back to being 1 day old.

The cooler colours on the top of the above chart show old coins – 7-10 years. These are probably lost coins (those who mined it and lost their secret ids). You can see how their proportion has steadily increased since the beginning of this year. The warmer colours in the bottom are new coins (1 day, 1 week etc). You can have a play around with this chart on this link here. But the trend is clear – coins that are in the 3m-6m, 6m-12m age bracket are being held on to. That is, people who got their tokens in the 3m-12m ago period are holding it. Those people who got it in the 3m-1m ago and 1m-1w ago period are quickly selling it, perhaps worried that price may fall further.

On-chain Analysis - Metric 3: Coin Days Destroyed (CDD)

Coin days destroyed is a metric which really measures the level of economic activity underlying BTC transactions. Simply measuring the total value of transactions only presents a partial picture of the underlying economic activity. For instance, I could send 10 coins between two addresses of mine 1000 times in one day and that would count as transactions worth 10,000 coins. But that isn’t really showing anything, is it? Coin days destroyed aims to fix this gap. It multiplies each transaction value by the ‘age’ of the coin. That way, older coins that get spent get a higher weightage than newer coins. When CDD is very high, the people who have been holding their coin for a long time are getting rid of it. When it is low, the opposite is happening. Check out the latest chart below.

CDD has consistently dropped since the beginning of January. Long-term holders of the coin are holding on, short-term holders are selling out.

On-chain Analysis - Metric 4: SOPR – Spent output profit ratio

This ratio measures profit. It is the realised value of BTC in USD to the value of BTC in USD when it was last transacted (purchased/mined). A ratio > 1 indicates, the holder sold it at a profit. The chart below shows how the SOPR has consistently decreased from January levels and is now below 1! This chart can also sometimes indicate overvaluation/undervaluation of Bitcoin price level. It has historically never fallen below 0.97 and never gone up above 1.06 – which can be used as short-term price pivots. The current value is just under 1.

On-chain Analysis - Metric 5: Futures open interest in exchanges

Now, this metric is an indication of speculative bids. It measures the total open interest in BTC futures across the different exchanges. The chart clearly shows how around late May the open interest drastically dropped and continues to be at subdued levels. This is because the pairs-trade (long BTC, short futures), which was quite profitable for a really long time, stopped being so at around that time. So a lot of futures traders left the market. Fewer the number of speculators in the market, lower the possibility of meteoric price rises that Bitcoin is well known for. How this metric will evolve over the next few months and how it correlates with BTC’s price will be interesting to see.

And like that, we are all an expert now in on-chain analysis 🙂

These are only some of the metrics I track. There are literally hundreds more and keeping track of all of them is a full-time job for a few people! But if you are keen, hop over to The Block or Glassnode.

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