Introduction to On-Chain Analysis

 

On-Chain Analysis

One of the characteristics of decentralized networks such as Distributed Ledger Technology (DLT) and blockchain is the availability of up-to-date versions of network data in the hands of its participants. This allows transparent and unobtrusive transaction data to provide a unique resource for analyzing events within the network. This type of analysis, which began with the advent of digital currencies, is called On-Chain Analysis .

 

What is On-chain Analysis ?

One of the principles and even the reasons for the formation of bitcoin is the attention to privacy and transactions in this network are unknown. While this is true, it also has an unexpected twist; While loyal to many (relatively) privacy principles, Bitcoin is also one of the most transparent (if not the most transparent) financial networks. As mentioned, on-chain analysis is performed using blockchain information and is a very powerful and efficient tool for monitoring and monitoring the activities performed in the network. The number of active or new addresses, the amount of transactions made in the network, the transaction fee, the activity of the old holders and the unusual movement of coins or tokens are just some of the things that can be recorded and evaluated by this analysis. The information of such networks is divided into two general categories:

 

 

UTXO model

Networks based on the UTXO model

The unspent transaction model or UTXO is an accounting method used in networks such as Bitcoin and its forks (such as Litecoin). In this method, inventory is recorded in the form of a number of unspent transactions, and with each new transaction, the previous unspent transaction is “consumed” and a new unspent transaction is created. As an intuitive example, a bitcoin transaction system can be thought of as a cash purchase. If you have a 50 dollars banknote and you want to pay for a product with a price of 30 dollars, you have no choice but to pay the total of 50 dollars and receive the rest of your money. Bitcoin does the same, but you do not need to trust the other party to return the rest of your money. The Bitcoin protocol does this automatically. This form of accounting makes it easier to analyze some issues. By tracking the desired 50 dollars banknote, it can be informed of its entry and exit date into each wallet and its storage period. On the other hand, indicators based on transaction volume (such as SOPR and CDD) have a double difficulty in determining the true amount of a transaction because of the concept of “remaining money”.

 

Account-Based Networks

These networks, led by Ethereum, use an account-based system. The type of accounting in this category can be considered similar to bank accounts. Each person has a certain balance, and when they receive or pay, an amount equal to the desired amount is transferred. The characteristics of this type of accounting make it difficult to deduce certain indicators. Because there is no difference between your inventories, some metrics cannot be extracted directly from information within the network and need to be analyzed by data collection services to provide similar quality to other networks. On the other hand, these networks (more precisely, the networks that support smart contracts and other assets – tokens) carry more information, such as gas fee.

 

A brief history of the On-chain analysis progress

The first On-chain index is almost as long as the Bitcoin network. The Coin Days Destroyed Index was created in 2011. It was also the first indicator to take advantage of the age of bitcoin addresses.

One of the first widely used in-chain metrics was the network-to-transaction value (NVT) ratio, developed by Chris Burniske and Jack Tatar and used on the Coinmetrics site. The NVT ratio was created in the summer of 2017 to determine the (real) functional value of a digital currency. This criterion is used in response to the question of how much the market values ​​the transactional use of a cryptocurrency.

By comparing the value of the network with the volume of transactions recorded in the blockchain, we can identify when a digital currency has been overvalued. The NVT ratio will be high when the value of the network is not justified by the volume of transactions. When considering transaction volume, if the value of the network is abnormally low, it may indicate that it is undervalued. The NVT ratio is often compared to the stock market price-to-earnings ratio (P/E) and is used in a similar way to find coins that have the potential to invest.

The NVT ratio improved over time. Other researchers have made changes to this criterion. For instance, the network value-to-transaction ratio (or NVTS) metric was created by considering the 90-day moving average of transaction volume. Recently, CoinMetrics updated this ratio using the free float supply. These gradual developments show how the basic valuation methods of a cryptocurrency are constantly evolving.

Another On-chain measure is made up of dissatisfaction with simple criteria derived from technical analysis (such as price to volume) and other concepts borrowed from traditional markets, such as market value. Market value is widely used by many comparison websites to rank digital currencies.

Nevertheless, since digital currencies are more like money or commodities (rather than stocks), market value is a (somewhat) misleading criterion. Market value rankings can be played and influenced through various methods of dissemination (multiplication). For example, if a token has a turnover of $1 trillion and only a few tokens are sold for $1; it will have a market value of $1 trillion, while its trading volume could be only a few thousand dollars.

Due to weak market value metrics and difficulties in using traditional metrics for digital currencies, a new set of tools has been developed that can help traders more accurately assess the health of blockchain networks.

Many of these metrics rely on the concept of UTXO (Unspent Transaction Outputs) in Bitcoin, which can be tracked to see when a wallet’s coins were last moved or how long an address held its coins. . The age, size, and number of UTXOs transmitted in a particular blockchain can provide reliable signals and are converted into in-chain metrics such as value achieved, HODL waves, and supply percentage in profit / loss.

The realized market value emerged as a bug-free method. Nic Carter and Antoine Le Calvez created this standard. This criterion sums up all the UTXOs and assigns a price to each UTXO based on the last time it was moved, and calculates the price based on that.

Further research was done on the metrics of realized capital and its output was the ratio of market value to real value (MVRV), which was created in October 2018 by Mahmoud Marov and David Powell. The MVRV ratio can be considered as an oscillator that has historically met certain thresholds indicating that bitcoin has been overvalued or undervalued. This criterion is accompanied by changes such as the MVRV Z score, the MVRV ratio of long-term or short-term holders, and is optimized for account-based blockchains, such as Ethereum.

 

On-Chain Analysis

How to get On-chain data?

A third-party non-dependent way is to set up a node on the network that you want to receive information from. Since the nodes keep a copy of the ledger. This method requires technical information, hardware and Internet connection, the prerequisites for this work vary according to the specifications of each network.

An alternative is to use data provided by data provider sites. You will usually have to pay a subscription fee to access the full range of data provided, but most of these sites also offer free plans. Some of these sites are CryptoQuant, Glassnode, Santiment, Lookintobitcoin and Intotheblock.

 

What are the limitations of On-chain Analysis ?

Despite the promise of this new possibility, it should be noted that this method is not yet complete and is improving. Some limitations of this method of analysis are as follows:

1. The lifespan of digital currencies is less than 15 years, and many of the historical results derived from indicators and metrics may not be valid in the future or our interpretation of them may change due to their short lifespan.
2. Scalability solutions such as the Lightning network for Bitcoin and optimistic solutions (Optimism and Arbitrum) for Ethereum, in addition to being less transparent, affect the volume of transactions in the Layer 1 network. With the increasing use of these solutions, one must either wait for the data to evolve in this network or consider their effect on the Layer 1 network.
3. For traders operating in very short timeframes, this data may not be of much value because their time horizon is usually longer. This group can use On-chain analysis as a complement to their first way of analysis.

 

In conclusion

On-chain analysis is one of the new methods of evaluating the financial information of the cryptocurrency market, which has been created due to the transparent nature of blockchain. This fledgling analytics framework still has a long way to go, yet it has nevertheless been able to find its place in the mental equations of traders. Many traders use this method as the only method or as a complement to another method. In this article, we talked about the differences between calculating On-chain ratios in the two common accounting methods of blockchain networks, provided a brief history of the progress of On-chain analysis , and outlined some of its limitations.