Will Bitcoin Rally on Fiat Currency Sanctions?

The financial sanctions imposed on Russia have brought renewed focus on bitcoin. The move to freeze the dollars and euros held by the Central Bank of Russia has highlighted an additional risk of holding fiat currency. And already, demand for bitcoin and crypto appears to be spiking in Russia.

Trading between stablecoins and the ruble on Binance have inclined sharply. The USDT/RUB pair recently registered new highs in trading volume above $35mn (Chart 2). This could indicate that Russians are attempting to get dollar exposure through stablecoins.

We are also seeing bitcoin trading at large premiums in Ukraine and Russia. Moreover, internet searches in Russia to ‘buy crypto’ have surged (Chart 3). Meanwhile, crypto donors are sending airdrops to support Ukrainians.

Risks Around Fiat Boost Crypto

Outside of Russia, we could start to see additional demand for bitcoin. This could come through institutions outside the US-EU alliance, such as those in China and India. These countries may therefore modify regulations to make holding bitcoin easier, at least for state-owned institutions. Meanwhile, retail investors worldwide may see heightened geopolitical risks as a reason to hold crypto too.

More Crypto Regulation Coming

However, there is a near-term bearish countercurrent. US and EU officials are discussing ways to clamp down on crypto transactions that could be used to evade Russian sanctions. ECB President Christian Lagarde, for example, is arguing for legislation for crypto exchanges and services to be barred for Russian clients. The White House and US Treasury are calling for crypto operators to cooperate with the US on sanctioning Russian entities.

The Russia sanctions could therefore spur new legislation to bring crypto into the traditional financial regulatory infrastructure. This could mean more ‘know your customer’ (KYC) and ‘anti-money laundering’ (AML) checks on individuals and institutions when they transfer their fiat currency into crypto.

Given the decentralised nature of crypto, the obvious target for regulators will be centralised exchanges. The so-called ‘on-ramp’ could therefore become more cumbersome. The uncertainty around this could deter institutional flows into crypto. In the long run, greater regulation could end up attracting more capital into crypto, but that will take time.

Another question is whether bitcoin will be the only crypto of choice for those concerned with fiat currency risk. All bitcoin transactions are on a public blockchain, which could deter investors. This potentially makes tracing transactions back to the buyer easier. Therefore, we could see more demand for privacy coins such as Monero or Zcash. These coins obscure transactions on the blockchain to maintain user anonymity. We have started to track the performance of these coins in our Crypto Index Tracker.

What Next?

Determining which of the above trends will dominate will take time. Bitcoin appears to have reduced its correlation to tech stocks (Chart 4). This could suggest the scepticism towards fiat currency may be helping bitcoin. Our flow metrics are also showing outflows from exchanges, which again could show investors prefer to hold bitcoin in more decentralised forms. We also see no clear outperformance of privacy coins versus bitcoin. However, we are seeing tentative signs of ETF outflows, which could suggest caution from institutional investors.

On balance, we still believe the macro backdrop is bearish bitcoin, while the on-chain/flow dynamics are positive. Therefore, we maintain a neutral stance in the near term.

Bitcoin Flow Metrics: On-Chain and Flow Dynamics

Our crypto metrics are giving a mixed bag of neutral to bullish signals. The bullish signals are:

• A bias for outflows from exchanges.
• Increasing futures open interest. We also note that the put-call ratio has resumed a downtrend.
• Increased profitability of the coin supply and a return to realised profits on chain.

The three neutral signals are:

• ETF inflows returned for a sustained period but have now returned to outflows – though small in magnitude.
• HODLers are still in an accumulation phase with no material shift between the <1y and 1y+ vintages.
• The hash rate and miner revenues took a hit. But hash rates have started to incline again.

On balance, these metrics are bullish bitcoin. The details are below, and the Appendix explains each metric.

Institutional Demand: Neutral Bitcoin

Our preferred metric to track institutional demand is flows into ETFs. Over the past two weeks, we saw a sustained period of ETF inflows (Chart 5). However, this week, we see flows flip back to outflows – albeit small in magnitude. At this stage, the signal is muted given the magnitude of the flows are small. We look for a sustained period of inflows or outflows to reconfirm a bullish or bearish stance. For now, we view this as neutral for bitcoin.

Demand for Liquidity and Exchange Activity: Bullish Bitcoin

In the short term, exchange flows have been mixed. But, on net, there is still a bias for outflows with around 4,000 coins exiting exchanges (Chart 6).

The month-on-month change of the exchange balance reveals how the net supply is changing over the medium term. This metric has shown exchange balance has been decreasing since 19 January and continues to do so. However, the magnitude of this decrease is waning (Chart 7).  

On both a short-term (weekly) and medium-term (monthly) basis, the exchange balance has shown a bias for outflows. The signals are more muted given they are much smaller in magnitude than we have seen in recent weeks. But this is a bullish sign, nonetheless.

Futures Activity: Bullish Bitcoin

Futures open interest is ticking up again. Total open interest sits around $14.6bn – up 8% WoW (Chart 8). Notably, around $9.9bn (68% of total futures open interest) is in perpetual futures contracts, suggesting a large majority of leverage remains in perpetuals.

Perpetual funding rates reveal the directional bias of investors. They have been volatile over the past week as Russia-Ukraine tensions continue to unfold (Chart 9). Currently, they are flat. However, eight out of the past 14 days have seen positive average funding rates, compared with six negatives, suggesting a slight bias for the upside – albeit relatively muted.

That futures open interest is rising again is constructive as it suggests increased investor interest. Funding rates are flat now, but this will change if prices continue to rise. Overall, view these metrics as bullish for bitcoin.

HODLers: Neutral Bitcoin

The 30-day moving average of the coin days destroyed (CDD) metric jumped on 28 February  as prices started to rally (Chart 10). CDD is calculated by taking the number of coins in a transaction and multiplying it by the number of days it has been since those coins were last spent. This means it is influenced by the transaction volumes as well as coin age.

To confirm the CDD spike was the result of older coin spending (and not just an increase in transaction volume), we can look at the 1y+ revived supply metric in tandem. This shows the number of coins that re-enter circulation (are sold) that have been previously untouched for at least one year. It spiked up on the same day – 28 February (Chart 11). Together, these metrics suggest some older hands came in to distribute coins and realise profits as prices rallied.

On balance, most coin holders are still in an accumulation phase, with 62% of the circulating supply having held for a year or more (Chart 12). If prices continue to rally and hold onto gains amid the geopolitical unrest surrounding Russia and Ukraine, we expect the <1y vintage to increase as more older hands begin to distribute into market strength and new buyers enter. We watch for a meaningful shift in the current trend of either vintage to signify potential shifts in HODLer sentiment.

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

Investor Profit and Loss: Bullish Bitcoin

On profitability, the percentage of circulating supply in profit (PSIP) is now 78%, up 11pp WoW (Chart 13).

Net unrealised profit/loss (NUPL) is 46% of market cap, up 8pp WoW (Chart 14). Year to date, NUPL has been below 0.5. It has tested this level on multiple occasions but has not yet been able to break through. If positive prices action persists and we see a sustained break above 0.5, historically, this would be a signal for further upside.

SOPR has been sitting above one this week, signifying a return to realised profits on chain (Chart 15).

Overall, increasing profitability is bullish bitcoin.

Mining Activity: Neutral Bitcoin

Russia is one of the largest contributors to the hash rate globally. The average hash rate took a hit from 18 February to 27 February as tensions between Russia and Ukraine intensified (Chart 16). Since then, it has picked up again – its currently up 15% over the last 30 days. Additionally, miner revenues fell during the same period (Chart 17).

The hash rate has proven its ability to recover from short-term shocks repeatedly, and we believe it will continue to rise. That miner revenues are decreasing is a bearish sign. However, it is expected given price action over the past two weeks. If prices continue to rise, we expect miner revenues to do the same. Overall, we view these metrics as a neutral sign 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: flows small in magnitude. Neutral bitcoin.
2. Liquidity demand: bias for outflows from exchanges. Bullish bitcoin.
3. Futures activity: increasing open interest. Bullish bitcoin.
4. HODLer behaviour: HODLers in an accumulation phase. Neutral bitcoin.
5. P&L of investors: increased profitability of supply and realised profits on chain. Bullish bitcoin.
6. Mining activity: hash rate recently took a hit, but is back on the rise. Neutral 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 O, 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 exceptionally 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.

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.