What Caused the Bitcoin Correction?

Bitcoin is in the middle of a 16% correction from highs. At around $57,000, it is currently trading at its lowest in almost six weeks (Chart 1). Pinpointing the precise trigger for the correction is hard, but it coincided with a sharp rise in the dollar and US yields. At the micro level, speculation has circulated around increased bitcoin release from a recent taproot network upgrade, increased selling from long-term HODLers and potential bitcoin supply unlocked from the Mt Gox fiasco.

Macro Drivers of Drawdowns

While the 16% correction is large, bitcoin markets have seen much larger corrections historically. Of the largest peak-to-trough drawdowns in bitcoin’s history, the current correction is outside the top 10 (Table 1). To better understand the characteristics of the larger drawdowns, we can track parallel developments in macro markets. We find a rising dollar and higher US yields are most correlated with the largest drawdowns. Meanwhile, equity market performance tends to give little signal. This suggests stabilisation of the dollar and US yields could mark the end of the current correction.

Micro Signals

Beyond macro, we can also determine whether bitcoin has reached extreme overbought or oversold levels. A measure of this is the MVRV z-score – the difference between bitcoin’s current market cap and the realised cap, expressed in standard deviation units. A high z-score implies the market valuation of investors’ bitcoin holdings is much higher than the valuation when they last transacted. It is like the price-to-book ratio in equity markets. We find the largest drawdowns tended to occur when the MVRV z-score is six or higher (Chart 2). We reached this level earlier in the year, and a 50% correction followed. But today, the z-score is much lower, suggesting we are not in extreme drawdown territory.

Our Flow Metrics

Two of our bitcoin metrics give bullish signals, three bearish, and one neutral. On the positive side, institutional interest is renewing and drainage from exchanges continues. On the negative side, futures open interest is falling, investors are taking profit, and the hash rate has decreased on average.

Punchline

We remain cautious on bitcoin in the near term. But at this stage, we do not envisage a 50+% drawdown. We monitor the dollar and investor profit taking to identify the next turn higher in bitcoin.

Here is the full rundown of our metrics:

Institutional Demand: Bullish Bitcoin

Our preferred metric to track institutional demand is flows into bitcoin ETFs (Appendix). Since dropping from new all-time highs, bitcoin ETF flows have resumed an uptrend (Chart 3). This renewed institutional interest comes despite bitcoin’s recent price pullback, which we consider bullish bitcoin.

We also track news around bitcoin, where momentum has been positive. Digital asset management firm Pantera Capital has raised $600mn for its fourth fund, with 75% of the capital coming from institutional sources such as pension funds, sovereign wealth funds and endowments. The latest CoinShares weekly report showed investors are ‘not fazed’ by the recent bitcoin correction, with digital asset investment products seeing inflows totalling $154mn last week – bitcoin comprised 90% of this. Lastly, Citi is hiring 100 people for its digital assets division, and Yahoo News recently reported that financial services firms have increased crypto talent hiring 40% in the first half of 2021. Overall, increasing ETF inflows and positive news momentum are bullish bitcoin.

Demand for Liquidity and Exchange Activity: Bullish Bitcoin

A measure of bitcoin bullishness is whether investors prefer to hold it in illiquid form (e.g., in a private wallet) or liquid form (e.g., on an exchange) (Appendix). The supply squeeze recently saw bitcoin prices hit new highs. Despite the current correction, supply continues to be removed from exchanges to cold storage. The past two weeks experienced a bias for outflows: 10 of the last 14 days saw outflows for a total net value of 30,510 coins moved off exchanges (Chart 4). The percentage of total bitcoin supply held on exchanges is now 12.82% – the last time it was this low was in February 2018 (Charts 5 and 6).

Throughout November, investors have continued to move their coins off exchanges – despite the recent price drawdowns. This is bullish bitcoin.  

Futures Activity: Bearish Bitcoin

We track bitcoin futures open interest – the sum of long and short contracts, which provides a good measure of investor interest. Open interest is trending down after recently registering new all-time highs, though is still historically elevated. It is currently down 1.7% month to date and 14.8% since the November highs (Chart 7). One of the biggest futures exchanges, Binance, provides a similar view – open interest is down 14% since the November highs (Chart 8). This is bearish bitcoin.

HODLers: Neutral Bitcoin

HODLing refers to buy-and-hold strategies in the context of cryptocurrencies. We categorise HODLers by the length of time they have held bitcoin (Appendix). Short-term HODLers (3m-6m) continue to convert to medium-term HODLers (6m-1y) or sold into the new highs (Chart 9). Medium-term HODLers are up 0.6pp month to date, whereas shorter-term HODLers are down 3pp month to date.

The coin days destroyed (CDD) metric is the number of coins in a transaction times 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. On average, CDD had been increasing until the new all-time highs, whereafter it has resumed a downtrend (Chart 10). This suggests that during the rally, older coins were increasingly being distributed to realise profits at the new highs. Historically, a bull market can withstand this distribution for many months before topping out. We examine how many coins re-entered circulation that previously had been untouched for over five years, finding that on average the value has jumped as bitcoin registered new highs (Chart 11). That is, old hands distributed into the new highs.

Overall, we view these HODLer dynamics as neutral bitcoin. A bearish case exists for older hands distributing, however, this is somewhat to be expected at new highs, which historically have seen similar patterns. Particularly, the number of coins being distributed is still lower than during previous bull runs.

Investor Profit and Loss: Bearish Bitcoin

Public blockchains allow us to calculate three P&L-related measures: percent supply in profit (PSIP), net unrealised profit and loss (NUPL) and the spent output profit ratio (SOPR). (The Appendix details each.)

The share of the supply in profit (PSIP) is currently 87.1%, historically a bull/bear transition zone, and is down 7.5pp month to date (Chart 12). The size of the unrealised profits (NUPL) is currently 57.7% of market cap, down 4.4pp month to date (Chart 13). The key level to look for here is 0.5 – were NUPL to drop below this, it could signal further downside. SOPR spiked briefly before the correction and is currently one (Chart 14).

Given the spike in profit taking at the new highs and that prices have subsequently dropped, pushing unrealised profits to monthly lows, we view these ratios as bearish bitcoin.

Mining Activity: Bearish Bitcoin

We track the hash rate for bitcoin. A higher rate means more computing power is available to maintain the network, deliver more security (resistance to attacks), and facilitate more transactions. We view this as a bullish sign (Appendix).

Bitcoin’s hash rate has been trending up since July and is on track to register new all-time highs. However, throughout the recent drawdowns, the hash rate has trended down on average (Chart 15). The case is similar for miner revenue (Chart 16). If bitcoin prices continue to fall and miner revenue softens, sell-side pressure from miners could weigh on sentiment as they sell to realise profits. Together, we view these as bearish bitcoin.   

Bottom Line

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

1. Institutional demand: increased ETF inflows and positive news momentum. Bullish BTC.
2. Liquidity demand: outflows from exchanges/exchange supply decreasing. Bullish BTC.
3. Futures activity: open interest decreasing. Bearish BTC.
4. HODLer behaviour: medium-term HODLers dominate, and older hands distribute coins at the new highs. Neutral BTC.
5. P&L of investors: unrealised profits decreasing. Bearish BTC.
6. Mining activity: hash rate and miner revenue decreasing on average. Bearish BTC.

On balance, the metrics are bearish bitcoin in the short term.

Appendix

Institutional Demand

Perhaps the largest institutional vehicle for bitcoin is the Grayscale Bitcoin Trust, with over $27bn in assets. It invests solely in bitcoin, and so many investors, notably institutional, who cannot hold bitcoin directly can get exposure through investing in Grayscale. Consequently, if the trust trades at a premium to bitcoin prices, it may imply ‘excess’ demand from institutions, but ‘excess’ supply if it trades at a discount. Alternatively, investors may be using other vehicles to get exposure such as ETFs or holding bitcoin 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 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. We can break this down further into those who have held bitcoin from the very early days (7-10 years ago and 10+ years ago).

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 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 BTC 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 coin) 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.