Ethereum Valuations Are Becoming Attractive

Ethereum has so far held up even after the Fed was more hawkish than expected. Over the past week, it has traded around flat. That said, at around $2,400, it is still amid a cumulative drawdown of 50% from its November 2021 highs (Charts 1 and 2). Moreover, ethereum has continued to underperform bitcoin throughout this selloff. Were the cross to fall to July 2021 levels, ethereum could reach $2,100, assuming bitcoin stays put (Chart 3).

In good news, valuations look increasingly attractive as the MVRV z-score approaches zero – historically a signal for market bottoms (Chart 4). Hash rates are also hitting new highs, suggesting the processing capabilities of the smart contract platform remains robust. We are also not seeing large flows onto exchanges, signalling investors are willing to keep their positions in less liquid forms and so are perhaps less eager to sell.

In bad news, we continue to see outflows from ETFs, and futures open interest is falling. But the wildcard remains the correlation between crypto markets and tech stocks. The new year seemingly produced a local regime shift – moving from relatively low to high correlation. We see high correlations with various tech stocks (the S&P 500, Russell 2000, and NASDAQ; Chart 5).

On balance, our flow and valuation metrics are showing signs of stability. Also, equity markets appear to have held up even after the Fed’s hawkish turn. Ethereum could therefore be nearing a more bullish period. We will be monitoring our metrics and equity markets before formally turning bullish. For now, we are neutral.

Our Flow Metrics in Detail

• We have three bearish signals: outflows from ETFs, negative funding rates amid decreasing futures open interest, and reduced profitability of the supply.
• We have one bullish signal: hash rates at new all-time highs amid decreasing transaction fees.
• Lastly, we have three neutral signals: long-term/short-term HODLers claiming roughly equal proportions of the circulating supply, muted changes in exchange balance and total value locked (TVL) in DeFi dropping but ethereum maintaining significant dominance.
• Overall, our metrics are neutral ethereum.

Below is a full rundown.

Institutional Demand: Bearish Ethereum

Our preferred metric to track institutional demand is flows into ethereum ETFs. Inflows returned last week but only briefly. Outflows have now resumed, though smaller in magnitude than this month’s earlier exodus. A significant bias for outflows has persisted throughout the new year, which is bearish for ethereum.  

Demand for Liquidity and Exchange Activity: Neutral Ethereum

Generally, 2022 has had pockets of increased inflows to exchanges and a steady stream of low-magnitude outflows (Chart 7). Over the past seven days, a net value of 44,336 coins entered exchanges. The 30-day change in the exchange balance is higher relative to the last 30 days, but the magnitude of its increase has been decreasing (Chart 8). Currently, 12% of the ethereum supply sits on exchange addresses. Overall, we view this as neutral – the inflow spikes are bearish; however, they are meaningfully lower in magnitude than previous selloffs.

Futures Activity: Bearish Ethereum

The dollar value of ethereum futures open interest has been falling since the start of the year. It is currently around $7bn – down 33% year to date (Chart 9).

Perpetual funding rates reveal the directional bias of investors. We can interpret funding rates as the cost of holding ethereum via perpetual futures. Positive funding rates imply longs pay shorts (traders are paying a premium to keep open long positions) and vice versa. They have been quite volatile over the past week and have again entered negative territory – this is bearish ethereum.

Overall, falling open interest and negative funding rates are bearish ethereum in the short term.

HODLers: Neutral Ethereum

The 30-day moving average of the coin days destroyed (CDD) (Appendix) metric shows little activity, suggesting muted movement of older coins (Chart 11). 

We split HODLers into those who have held for under one year and those for one year or more. Some shorter-term HODLers (<1y) have converted to longer-term HODLers (1y+) throughout the deep selloff (Chart 12). The proportion of circulating supply held by the two groups is roughly equal. Generally, there appears more correlation between price action and the <1y vintage recently, suggesting prices could pick up if this vintage were to start increasing again. We will investigate this in a separate note and take a neutral stance currently.

An important upgrade to the ethereum ecosystem is expected in Q1/Q2 this year: the official switch of consensus protocol from proof-of-work to proof-of-stake. Proof-of-stake requires users to stake 32 ETH to become a validator (analogous to miners) on the network. We monitor the number of addresses with at least 32 ETH in the run-up to the merge as these are potential validators for ETH 2.0 – there are currently 107,077 (Chart 13).

Investor Profit and Loss: Bearish Ethereum

On profitability, the percentage of circulating supply in profit (PSIP) is now 70% (Chart 14). Notably, this is comparable to July 2021 levels when prices were climbing out of the initial Covid-19 shocks.  

Net unrealised profit/loss (NUPL) has dipped sharply to 0.35 (Chart 15). Hitting 0.25 is a historically key level to signify further downside, so we watch it closely.

SOPR has been below one since 17 January, signifying realised losses on chain. The last time SOPR remained below one for any meaningful period was during the June/July 2021 selloff (Chart 16).

Mining Activity: Bullish Ethereum

The hash rate continues to diverge from the price trend to register more all-time highs (Chart 17).  Ethereum is often criticised for its high transaction costs, but the mean gas price paid per transaction has been decreasing on average over the past week (Chart 18).  

Higher hash rates and lower transaction costs are bullish ethereum.

DeFi: Neutral Ethereum

We track the total value locked (TVL) in DeFi – the sum of all assets deposited in DeFi protocols, many of which use ethereum as the underlying protocol. The more DeFi products are created, the more ethereum gets locked into the DeFi system and removed from the broader market. This reduction in supply should lead to higher ethereum prices.

The overall TVL has suffered during the selloff as smart contract platforms and DeFi coins in general have been hit quite hard. Ethereum is still the dominant player in the space, but competitors such as Terra and Fantom are on growth trajectories (Chart 19). So far, no other chains compete with ethereum on TVL. That said, ethereum’s TVL is down 15% week on week. We still view ethereum’s dominance as bullish, but the broader selloff and subsequent plummet in TVL provide a more cautious backdrop – overall, this is neutral ethereum.

Bottom Line

We have introduced a framework for understanding the flow and microstructure dynamics of ethereum markets. The seven key metrics are:

1. Institutional demand: outflows from ETFs. Bearish ethereum.
2. Liquidity demand: small changes in exchange balance. Neutral ethereum.
3. Futures activity: funding rates turn negative and decreasing open interest. Bearish ethereum.
4. HODLer behaviour: small difference between long-term and short-term HODLers. Neutral ethereum.
5. P&L of investors: reduced profitability of supply and realised losses on-chain. Bearish ethereum.
6. Mining activity: hash rate hitting new all-time highs and gas prices decreasing. Bullish ethereum.
7. DeFi activity: overall TVL in DeFi drops but ethereum maintains dominance. Neutral ethereum.

Appendix 

Institutional Demand 

Perhaps the largest institutional vehicle for ethereum is the Grayscale ETHE Trust, with over $27bn in assets. It invests solely in ETH, and so many investors, notably institutional, who cannot hold ETH directly can get exposure through investing in Grayscale. Consequently, if the trust trades at a premium to ETH prices, it may imply ‘excess’ demand from institutions, but ‘excess’ supply if it trades at a discount. Alternatively, the discount may suggest investors have found other ways to get exposure to ETH, whether through ETFs or directly holding ETH. We therefore focus on how the discount has changed in recent months to gauge investor interest.  Alternatively, investors may be using other vehicles to get exposure such as ETFs or holding ETH directly. We put more weight on ETF flows than the Grayscale premium.  

Liquidity Demand 

Another measure of cryptocurrency bullishness is whether investors are willing to hold it in illiquid form (e.g., a private wallet) or prefer a liquid form (e.g., on an exchange). The former would suggest investors are bullish, as they are comfortable with being unable to sell easily. Conversely, holding it in liquid form would suggest investors are bearish, as they prefer being able to sell easily.  

Therefore, large flows onto crypto exchanges would suggest investors want to convert their holdings to a more liquid form, possibly implying more bearishness. 

HODLers 

In our introductory bitcoin flow framework, we explained ‘HODLers’ and ‘HODLing’. HODLing refers to buy-and-hold strategies in the context of bitcoin and other cryptocurrencies. Those who HODL for long periods are die-hard adherents.  

We can categorise HODLers by the length of time they have held ETH. We define long-term or staunch HODLers as those who bought ETH five or more years ago and have held it ever since, medium-term HODLers as those who bought 6-12 months ago, and short-term HODLers as those who bought 3-6 months ago.  

The coin days destroyed (CDD) metric is defined as the number of coins in a transaction multiplied by the number of days since the coins were last spent. So, increasing CDD suggests older coins are being spent (more coin days are destroyed) and vice-versa. 

Profit and Loss 

• The percent supply in profit (PSIP). This tracks the share of circulating ETH supply in profit. That is the percentage of circulating ETH whose current price is higher than when it was last transacted (movement).  

• Net unrealized profit and loss (NUPL). This is the ratio of unrealised profits over total market capitalisation. While PSIP just focuses on whether ETH coins are in profit or not, the NUPL focuses on the size of profits. So, we could have a situation where the PSIP is low – that is, a low share of supply is in profit – but the NUPL could be high if the size of those profits is very large.  

• Spent output profit ratio (SOPR). While PSIP and NUPL focus on unrealised profits or mark-to-market, this measure focuses on realised profits. SOPR is the realised value of a transaction divided by the value at initiation (or creation) – more simply, price sold divided by price paid. If SOPR is above one, investors in aggregate have realised profits, while below one means they have realised losses. In broad uptrends, SOPR spends a significant amount of time above one, whereas the opposite is true for broad downtrends.  

When SOPR is rising, sellers are increasingly realising profits. The opposite is true when it is falling. A price rally with a flatter SOPR trend indicates investors are not yet realising their profits with the rally. The reluctance of investors to sell and realise a profit may be because they believe the price will increase further, which would be bullish. At the same time, more profit taking could precede a correction. Typically, buying as SOPR moves around one during bullish periods has proven to be a profitable strategy.  

Mining Activity 

Computing power is central to the crypto market. Miners use advanced computing hardware to solve complex problems that confirm ETH (and other coins) transactions on the public ledger or blockchain. The miners are rewarded with new coins for their efforts. A measure of the complexity of the problems and so the computing performance required to solve them is the hash rate. The higher this rate, the more computing performance is needed to maintain the blockchain. The rate can fluctuate depending on demand for crypto.  

Dalvir Mandara is a Quantitative Researcher at Macro Hive. Dalvir has a BSc Mathematics and Computer Science and an MSc Mathematical Finance both from the University of Birmingham. His areas of interest are in the applications of machine learning, deep learning and alternative data for predictive modelling of financial markets.