Flows Turn Negative for Ethereum

Crypto markets continued to weaken over the past week on Fed hawkishness. In particular, smart contract platforms and decentralised finance (DeFi) were hit hard, with several major coins down 10%+. Ethereum has underperformed bitcoin lately (Chart 1) and is down 33% from the previous all-time high (Chart 2). The total crypto market cap currently sits at $2tn, with ethereum claiming a 19% dominance.  

Recent price action comes as crypto markets trade with broader risk sentiment rather than crypto-specific dynamics. Looking at traditional macro markets, we find ethereum is most correlated with two-year yields, NASDAQ, oil, and gold in the short term (30 days). And it is most correlated with 10-year yields and the S&P 500 in the longer term (180 days) (Chart 3).  

One way to distinguish ethereum from bitcoin is examining the differences in seasonality at the start of the year. Considering prices over January since 2016, ethereum saw positive returns in all but one year (2019), whereas four of the last six years showed negative returns for bitcoin (Chart 4). It appears ethereum performs better at the start of the year, although recent price action indicates a potential shift in this dynamic as ethereum is underperforming bitcoin.  

What Our Flow Metrics Tell Us  

• Overall, our flow metrics are giving a bearish signal for ethereum in the near term. 
• We have four bearish signals: ETF outflows, increasing exchange balance, negative funding rates, and reduced profitability of the supply.  
• We have one bullish signal: increased proportion of longer-term HODLers.  
• Lastly, we have two neutral signals: hash rate increases as gas prices rise, and overall total value locked (TVL) in DeFi decreases, but ethereum remains dominant.  

• A turning point could be underway. Prices have started to recover, and markets appear to be shrugging off higher CPI prints. But for confirmation, we need our flow metrics to turn more bullish – currently, they are giving bearish signals in the near term.  

Here is the full rundown of our metrics: 

Institutional Demand: Bearish Ethereum 

Our preferred metric to track institutional demand is flows into ethereum ETFs. Net inflows flipped to outflows in early December 2021. And after a brief spell of inflows toward the end of 2021, we are again seeing large outflows lately (Chart 5). This is bearish ethereum.   

On news around ethereum, Norton 360 antivirus now comes with a built-in crypto mining tool that will allow users to freely mine ETH. Ethereum co-founder Vitalik Buterin proposed multidimensional EIP-1559 to address gas fee markets. Lastly, analysts at JP Morgan suggest ethereum’s dominance in DeFi markets is ‘far from given’, with competing blockchains receiving lots of funding amid ethereum’s scaling issues.  

Demand for Liquidity and Exchange Activity: Bearish Ethereum 

There were numerous inflow spikes throughout December 2021. With a net value of 430,392 coins entering exchanges for the entire month, it was the first month to see overall net inflows since May 2021. The start of 2022 has shown mixed, but muted, activity on this front – there has been a net value of 67,789 coins coming off exchanges year-to-date. 

The total exchange balance sits in an overall downtrend. However, it has resumed an uptrend in the short term. Currently, 15.5mn coins (12.3% of total circulating supply) are held on exchange addresses (Charts 7 and 8) – up 3% since the start of December 2021. The increasing exchange balance suggests investors increasingly want to hold it in a liquid form for easier selling – this is bearish ethereum. 

Futures Activity: Bearish Ethereum 

Ethereum futures open interest has been falling. It is currently down 30% from the start of December 2021 (Chart 9), suggesting muted investor interest on this front.    

Perpetual funding rates reveal the directional bias of investors. Exchanges set funding rates to prevent a lasting divergence in the price of the futures contract and the underlying since perpetual contracts have no expiry date so never settle in the traditional sense.  

Consequently, we can interpret funding rates as the cost of holding ethereum via perpetual futures. Positive funding rates imply longs pay shorts and vice versa. We use it as a proxy for trader sentiment since a positive funding rate implies traders are paying a premium to keep open long positions. They have been decreasing on average and are now negative (Chart 10), meaning investors are paying a premium to keep open short positions.   

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

HODLers: Bullish Ethereum 

The 30-day moving average of the coin days destroyed (CDD) (Appendix) metric has been increasing on average. This suggests movement of older coins has picked up (Chart 11).  

Splitting HODLers into those who have held for under one year and those for one year or more reveals the latter cohort has recently jumped (Chart 12). This suggests a decent proportion of shorter-term HODLers (<1y) converted to longer-term HODLers (1y+) into the new year, reinforcing their conviction to hold even through tumultuous price action.  

Currently, there is around a 50/50 split of the total ethereum supply between the two cohorts – any divergence from here will be of interest. The increase in longer-term HODLers is bullish ethereum.  

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. The current network for ethereum is known as the Mainnet. It operates on a proof-of-work consensus and is due to merge with the Beacon Chain, which currently exists separately, signifying the official switch to proof-of-stake consensus.  

In short, proof-of-stake requires users to stake 32 ETH to become a validator on the network. Validators are analogous to miners in the traditional proof-of-work protocol, and their responsibilities are the same: ordering transactions, creating new blocks and ensuring network security. 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 around 108,000 (Chart 13).  

Investor Profit and Loss: Bearish Ethereum 

On profitability, the percentage of circulating supply in profit (PSIP) is currently only 76%, down 5pp year to date (Chart 14). Notably, this is comparable to levels last seen in July 2021, whereafter prices rallied.  

Net unrealised profit/loss (NUPL) is currently 0.5 (Chart 15). We will be watching carefully if this slips below 0.5, as it could signify further downside.  

SOPR has been below one since last Wednesday, signifying realised losses on-chain over the past week. The decrease in the profitability of the circulating ethereum supply and realised losses on-chain are bearish ethereum.  

Mining Activity: Neutral Ethereum 

The hash rate continues to consistently register new all-time highs and has diverged from downward price action (Chart 17). Ethereum is often criticised for its high transaction costs and the mean gas price paid per transaction has been increasing on average quite sharply since the start of the year (Chart 18) – it is up 91% year-to-date – this is bearish ethereum.  

That the hash rate continues to increase is constructive, but increasing gas prices add to the narrative that ethereum has a gas problem. Together, we view these as neutral for 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.  

TVL across all chains has dropped from highs of $280bn to around $240bn throughout the sell-off. Ethereum still maintains the largest share at $147bn (Chart 19) – but this is down 7% week on week. That ethereum maintains dominance in the DeFi space is positive, but the drop in overall TVL is negative. Additionally, other blockchains are claiming an increasing dominance in DeFi. And given these competing protocols are increasingly receiving more funding, they are a very real threat to ethereum’s dominance should its scaling issues find no resolution soon. Together, we view this as 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: overall exchange balance increasing week on week. Bearish ethereum. 

3. Futures activity: funding rates turn negative. Bearish ethereum. 

4. HODLer behaviour: long-term HODLer proportion increases. Bullish 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 but gas prices increasing. Neutral ethereum. 

7. DeFi activity: overall TVL in DeFi drops but ethereum maintains dominance. Neutral ethereum. 

Overall, our indicators are giving a bearish signal for 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.