The Crypto Quake Has Started

Summary

Trading View (next 2-4 weeks): We like to be bearish bitcoin.

Investment View (next 1-3 years): We like to be long bitcoin.

Macro Signals

• Higher US rates have caught up to bitcoin, which has now plunged 20% since the Fed meeting last Wednesday.
• Tighter liquidity conditions will continue to hurt risk markets like crypto, and correlations to other asset markets like tech stocks will stay high.
• We also see pressure in stablecoins like TerraUSD, which have some parallels to FX pegs in the real world.
• The macro backdrop remains bearish.

On-Chain/Flow Signals

• Our metrics are split this week: two bullish signals, three bearish signals, and two neutral signals.

Overall View

• With the macro signal remaining bearish and on-chain/flow metrics bearish on balance, our overall signal is bearish bitcoin (Chart 1).

Macro: Markets Digest the Fed Rate Hike

Crypto markets almost looked like they had partial immunity from the tech sell-off and growing risk aversion. But price action over the past week has put paid to that notion. The relative stability of bitcoin between mid-January and mid-April, when it choppily trended up with higher highs and higher lows, was simply the calm before the storm. Bitcoin has now plunged 20% since the Fed meeting last Wednesday (Chart 2). And there is likely more to come.

The crux of the matter is that US interest rates are rising. Years of low interest rates since the global financial crisis in 2008 have seen markets reach extreme valuations. Who cares if tech companies are loss-making if the companies can borrow easily? And if companies cannot borrow money, they can attract capital from investors, who themselves have likely borrowed money.

Crypto markets have not been immune to the support from cheap leverage in the fiat markets. After all, crypto offers the tech dream of scalability and regulatory arbitrage. And if there was any doubt that crypto was not benefiting from low interest rates then the recent declines in crypto as US rates have risen should remove it.  

Furthermore, the correlation of bitcoin to NASDAQ started to increase sharply just as US interest rates started to rise (Chart 3). This is a common occurrence throughout history. When the liquidity tap turns off, usually by central banks raising rates, the correlation between diverse assets shoots up. This time appears no different.

Complicating this matter are lags between when rates rise and risk markets unwind. After all, the Chinese yuan was a haven of stability until it recently plunged (Chart 4). This time it appears to be bitcoin’s turn.

Other areas of crypto that could be particularly vulnerable to rates are stablecoins. The currency pegs of countries have been prone to break when the Fed raises rates. Already, we are seeing the USD-HKD peg face pressure and test the upper bound of its target range (Chart 5). In crypto land, the Terra stablecoin appears to be the first major victim. It should trade at 1:1 with the US dollar. But it has recently de-pegged and continues to trade below par (Chart 6). The Luna foundation has stepped in to try to stabilise the coin.

But the bottom line is that crypto, including bitcoin, will remain under pressure. For bitcoin, this means a breach of 30,000 is possible. The main near-term support would be Fed dovishness rather than any crypto-specific dynamics. And for long-term investors, we still think some allocation to crypto makes sense – just like an allocation to equities also makes sense. But be prepared for near-term weakness. Good luck.  

On-Chain/Flow: Futures Open Interest Plummets

Two metrics are giving bullish signals this week:

• Bias for exchange outflows.
• Longer-term HODLer vintage rises despite negative price action.

Three metrics are giving bearish signals:

• Reduced profitability of the coin supply and realised losses on chain.
• Hash rate and miner revenues decline.
• Futures open interest is decreasing.

Lastly, the remaining metric is giving a neutral signal:

• ETF inflows return, but they are small in magnitude and have not been sustained for a meaningful period yet.

On balance, on-chain/flow metrics are giving a bearish signal. Here are the details of each metric (with explanations in the Appendix).

Institutional Demand: Neutral Bitcoin

Our preferred metric to track institutional demand is flows into bitcoin ETFs. There has been a noticeable bias for outflows since the end of March (Chart 7). However, inflows return recently – though small in magnitude. And we want to see them sustained for a meaningful period before reconfirming a bullish signal on this front. Overall, this is neutral bitcoin.

Demand for Liquidity and Exchange Activity: Bullish Bitcoin

In the short term, a bias for outflows from exchanges exists. Net 800 and 12,000 coins left exchanges over the past seven and 14 days, respectively (Chart 8). However, there have been some singular instances of inflow spikes recently too. There have been net outflows for 11 of the last 14 days.

Longer term, the 30-day change in the exchange balance reveals fluctuations in the supply held on exchanges month on month. Relative to the last 30 days, this metric remains in negative territory (Chart 9). This is bullish bitcoin.

A bias for exchange outflows in the short term and the longer term is bullish bitcoin.

Futures Activity: Bearish Bitcoin

Futures open interest is trending down – it is currently $12.3bn, down 13% and 18% over the past seven and 14 days, respectively (Chart 10). Around $8.1bn (66%) of this comes from perpetual futures contracts.

Perpetual funding rates reveal the directional bias of investors. On average, they have resumed a downtrend (Chart 11).

HODLers: Bullish Bitcoin

The 30-day moving average of the coin days destroyed (CDD) metric has ticked up slightly (Chart 12), indicating some older coin selling. Looking at the 1y+ revived supply metric confirms this – it is also slightly up over the same period (Chart 13). Most of the coin supply (65%) have been accumulating for a year or more (Chart 14).

Despite increasing concerns around Fed tightening, risks around the Russia-Ukraine war, and a potential recession, longer-term HODLers (1y+) maintain an impressive conviction to hold. We view this as a bullish sign for bitcoin.

Investor Profit and Loss: Bearish Bitcoin

The percentage of circulating supply in profit (PSIP) has dropped to 65% (Chart 15). That is down 7pp over the past seven days. Net unrealised profit/loss (NUPL) is now 0.3 – down 8pp over the past seven days (Chart 16). Lastly, SOPR is displaying a bias for realised losses on chain with a value less than one for 13 of the last 14 days (Chart 17).

Overall, the reduced profitability of the coin supply and realised losses on chain are bearish for bitcoin.

Mining Activity: Bearish Bitcoin

The hash rate is down 8% over the past seven days but remains close to all-time highs (Chart 18). Miner revenues have followed suit – they are down 15% over the past seven days (Chart 19). Together, these metrics are bearish for bitcoin.

Bottom Line

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

1. Institutional demand: ETF inflows return, though small in magnitude. Neutral bitcoin.
2. Liquidity demand: long-term and short-term bias for exchange outflows. Bullish bitcoin.
3. Futures activity: futures open interest trending down. Bearish bitcoin.
4. HODLer behaviour: longer-term HODLers maintain conviction despite negative price action. Bullish bitcoin.
5. P&L of investors: decreased profitability of the coin supply and a bias for realised losses on chain. Bearish bitcoin.
6. Mining activity: hash rate and miner revenues decreasing. Bearish bitcoin.

Appendix

Institutional Demand

Perhaps the largest institutional vehicle for bitcoin is the Grayscale Trust, with over $27bn in assets. It invests solely in BTC, and so many investors, notably institutional, who cannot hold BTC directly can get exposure through investing in Grayscale. Consequently, if the trust trades at a premium to BTC 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 BTC, whether through ETFs or directly holding BTC. 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 BTC directly. We put more weight on BTC 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, implying more bearishness.

Futures Activity

We track the growing market of bitcoin futures. Open interest – the sum of long and short contracts – is a good measure of investor interest.

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 bitcoin 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.

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 extended periods are die-hard adherents.

We can categorise HODLers by the length of time they have held BTC. We define long-term or staunch HODLers as those who bought BTC 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 BTC supply in profit. That is the percentage of circulating BTC 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 BTC 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 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 BTC (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.