We Turn Bullish Ethereum

Crypto markets have made impressive gains in February. Our crypto indices show sizeable gains in smart contract coins like ethereum to metaverse coins. Importantly, this comes as the market has priced more Fed hikes and the ECB has pivoted to potential hikes in 2022. That crypto can rally even with expected tighter liquidity conditions suggests macro factors could be affecting them less than before. We see this in the correlation between ethereum and tech stocks – it has fallen from the highs of 75% last week to 60% this week (Chart 2).

For ethereum-specific metrics, the picture has turned more positive:

• Valuations are attractive, with an MVRZ z-score currently at 1.18. Inflows to ethereum ETFs have also returned.
• On derivatives markets, futures open interest is rising. Currently, around 80% of total open interest is dominated by perpetual futures whose funding rates are now positive on average. This suggests a directional bias for the upside within leveraged markets.
• The put-call ratio has started to flatten out from its recent incline – it is currently around 0.35 (Chart 3). This is much lower than during the May-July 2021 sell-off.
• The hash rate continues to register new all-time highs, gas fees are decreasing, and the profitability of the coin supply is rising again.

Our other two metrics are neutral. We see small changes in the overall exchange balance recently and are yet to see an uptick in HODLers who have held coins for less than a year. Also, the number of addresses with at least 32 ETH (potential validators for ETH 2.0) is increasing slowly. We detail the ethereum metrics in the next section, with the Appendix explaining each.

Overall, we still think the macro backdrop is negative for crypto, but our on-chain/flow metrics have turned more positive (five bullish signals and two neutral signals). On balance, we therefore turn moderately bullish on ethereum from neutral (Chart 1).

Institutional Demand: Bullish Ethereum

Our preferred metric to track institutional demand is flows into ethereum ETFs. Inflows have returned after a spell of huge outflows (Chart 4). This is bullish ethereum, but, as the past few months showed, a return to inflows can sometimes be met with sharp returns to outflows. So we are cautious around this narrative. For greater confidence, we want to see a more sustained period of inflows, but the signs are positive.

Demand for Liquidity and Exchange Activity: Neutral Ethereum

The past week saw a consistent bias for outflows, with net outflows on five of the last seven days (Chart 5). Net 24,262 coins left exchanges over the past week as prices ticked up. This is bullish ethereum.

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, the exchange balance has recently been fluctuating little (Chart 6).

Throughout the broader sell-off, this metric showed material increases in the exchange balance – more so than during the May-July 2021 sell-off. This contrasts bitcoin dynamics, which had much smaller increases in the exchange balance during the recent sell-off versus that of May-July 2021. This suggests more investors preferred to hold coins in a liquid capacity during the current sell-off than the May-July 2021 one, which is bearish. However, from mid-January onward, the magnitude of the changes has lowered significantly, which is constructive.

Short term, a bias exists for outflows. Longer term, we have seen more inflows month on month during the current sell-off than the May-July 2021 one. Together, we view this as neutral ethereum.

Futures Activity: Bullish Ethereum

Futures open interest trended up recently. It is currently around $8.3bn – up 18% over the past two weeks and 8% on the week (Chart 7). Around $6.7bn (80%) of this comes from perpetual futures contracts, so a large majority of leverage sits in perpetuals.

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 returned to positive territory after dropping below zero multiple times over the past few weeks (Chart 8).

Overall, a large majority of open interest sits in perpetual futures contracts, which look to have a directional bias for the upside with funding rates slowly rising. This is bullish ethereum.

HODLers: Neutral Ethereum

The 30-day moving average of the coin days destroyed (CDD) metric continues to show little activity, suggesting muted movement of older coins (Chart 9). To validate this, splitting HODLers into those who have held for under one year and those for one year or more reveals the latter proportion has been increasing recently (Chart 10). Given the correlation between the <1y vintage and price action seems to be higher recently, we look for an increase in this vintage to signify further upside.

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 107,762, and this is increasing slowly (Chart 11).

On balance, we view these HODLer metrics as neutral ethereum.

Investor Profit and Loss: Bullish Ethereum

The overall profitability of the ethereum ecosystem is starting a healthy recovery. The percentage of circulating supply in profit (PSIP) is now 80% (Chart 12) – up 10pp over the past two weeks.

Net unrealised profit/loss (NUPL) is back to 0.5 (Chart 13). A push above 0.5 has historically signified further upside should price momentum continue – we will be watching this closely.

SOPR returns to levels above one after being below one during the second half of January and start of February (Chart 14). This signifies a return to overall realised profits.

Mining Activity: Bullish Ethereum

The hash rate continues its upward trajectory and registers more all-time highs (Chart 15). It is up 8% from the start of 2022 and a staggering 240% from the start of 2021. 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 16).

Higher hash rates and lower transaction costs are bullish ethereum.

DeFi: Bullish Ethereum

We track the total value locked (TVL) in decentralized finance (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 suffered during the sell-off as smart contract platforms and DeFi coins in general were hit quite hard. However, the same sectors are doing well in the subsequent recovery. Accordingly, TVL looks to have begun its own recovery. Ethereum currently maintains significant dominance, with $123bn of $208bn TVL coming from the Ethereum chain alone (Chart 17). The top five chains have all seen increases in TVL over the past week except for Fantom (Chart 18).

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: return of inflows to ETFs. Bullish ethereum.
2. Liquidity demand: small changes in exchange balance recently. Neutral ethereum.
3. Futures activity: funding rates turn positive and increasing open interest. Bullish ethereum.
4. HODLer behaviour: long-term HODLer share increasing and the number of ETH 2.0 potential validators slowly increasing. Neutral ethereum.
5. P&L of investors: increased profitability of supply and realised profits on-chain. Bullish ethereum.
6. Mining activity: hash rate rallying and mean gas fees decreasing. Bullish ethereum.
7. DeFi activity: TVL starts to recover and ethereum maintains dominance. Bullish 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, 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 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.