The Week On-chain Newsletter

The Growing Dominance of Perpetual Swaps

Yields, implied volatility and trading volume in Bitcoin derivatives markets continue to compress, leading to an aggregate decline in capital inflows. On-chain volumes also remain muted, however, more constructive medium to long term fundamental trends are starting to develop.

Checkmate, Glassnode

Apr 25, 2022 • 10 min read

Volatility and trading volume continues to compress across the Bitcoin market, as prices remain bound within the $38k to $42k consolidation range. Market prices weakened slightly again this week, trading off a high of $42,893, and losing ground at a weekly low of $38,729.

The market has now traded within an increasingly tight price range for almost three months, leading to historically low yields available in futures markets cash-and-carry trades, alongside a persistent decline in trade volumes. Implied volatility priced into options markets has also broken below 60% this week, which is significantly lower than the 80%+ volatility that characterised much of 2021. Furthermore, transaction volumes on-chain remain muted, albeit with a growing trend of high value ($10M+) transactions, and a macro decline in volumes associated with exchange inflows and outflows.

In this edition, we will focus on a number of these big picture trends that are developing in Bitcoin markets, including:

Compressing trade volumes, low implied options volatility, and rolling basis yields persistently below 3% in futures markets. All are leading to a leaking of capital out of Bitcoin markets as investors seek higher returns elsewhere.
The dominance of perpetual futures markets continues to grow, as these instruments have clearly become the preferred source of leverage.
Declining on-chain settlement volume, however with a growing dominance of large size transactions ($10M+).
Cyclical divergence between exchange related inflow/outflow volume, and total transaction volume. This accompanies a potential shift in momentum with respect to network utilisation, and provides a potentially constructive reversal in the fundamentally implied valuation for Bitcoin.

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Perpetual Futures Dominance On The Rise

Over the last five years or so, the market for Bitcoin derivatives has grown and matured in leaps and bounds. It has transitioned from a small fraction of spot trade volume in 2017, to now represent the dominant venue for price discovery. Futures trade volume now represents multiples of spot market volume.

Nevertheless, the aggregate futures trade volume has been in a macro decline since Jan 2021. During the first half of 2021, trade volumes between $70B and $80B per day were typical. In the current market however, futures trade volumes are down over 59%, currently around $30.7B/day. There was barely an uptick in Oct-Nov 2021, even as prices pushed to new all-time-highs.

Open interest in futures markets is also notably lower than it was during peak bullish periods, currently hovering around $15 Billion, with a 2:1 split between perpetual futures, and calendar expiring futures. Current open interest is similar to levels seen in the May-Sept 2021 period, but remains 36.8% below the $22.5B+ peaks set in April, and again in November.

Perpetual futures are increasingly becoming the preferred instrument for trading, a trend that can be clearly visualised in the dominance chart below:

Blue represents the dominance of perpetual swap trade volume compared to the total futures volume, showing a remarkable 92.4% dominance at present. This has increased from 75% dominance in Dec 2020 as the market broke through last cycles $20k ATH.
Pink represents the same dominance concept, but applied to futures open interest, which has risen from 50%, to over 66% dominance since Dec 2020.

In many ways, this trend is expected, and is likely a result of a few key factors:

Perpetual swaps more closely match spot index pricing, thus making it easier and more intuitive for traders to manage positions and leverage.
Low storage and delivery costs associated with digital assets negates many of the benefits of calendar futures when compared to physical commodities. Calendar futures provide useful tools for hedging risk, and pricing future production and delivery costs for physical commodities, however these costs approach zero for Bitcoin.

This trend also be seen in the Futures Leverage Ratio, which remains in a structural uptrend. This reflects a growing trend of the market deploying capital preferentially into perpetual swap markets, rather than calendar futures. The current open interest in perpetual swaps is equivalent to 1.3% of the Bitcoin market cap, which is approaching historically high levels.

However it should be noted that the aggregate leverage ratio for all futures markets has actually declined over the last two weeks, falling from 2.1% in early April, to 1.9% today. As such, whilst perpetual swap open interest is relatively high, there is an even larger aggregate transfer of capital and leverage out of calendar expiring futures, creating a net decline in overall leverage.

Yield and Volatility Compression Continues

A declining leverage ratio across all futures markets, despite increasing leverage in perpetual swaps, suggests that a reasonable volume of capital is actually leaving the Bitcoin market. This is further supported by the declining trade volumes shown above.

If we look at perpetual swap funding rates, we can see that the majority of 2022 has seen very low available yields, and little directional bias. This is a stark contrast to the hyper-bullish long speculation in H1-2021 and again from Aug-Nov, and periods of extreme bearishness in May-July 2021.

If we annualize the perpetual funding rate, and compare it to the 3-month rolling basis available in calendar futures, we can see a likely reason behind why capital is rotating out of Bitcoin markets.

Yields available in futures markets have compressed to levels barely above 3.0%, which is hardly superior to the yield available from a 10y US treasury bond (2.9%), and significantly lower than the recent US CPI inflation print of 8.5%. It is likely that declining trade volumes and lower aggregate open interest is a symptom of capital flowing out of Bitcoin derivatives, and towards higher yield, and potentially lower perceived risk opportunities.

We can also see that options markets are pricing in historically low implied volatility, breaking below 60% over the past few weeks. There are very few instances in the last year where implied volatility has been this low, most of which are during the current consolidation range which has contained almost all of the year-to-date price action.

With low implied volatility in options markets, options short sellers are in a similar, low yield boat, as cash-and-carry futures traders.

We can also see a general shift in sentiment and risk management in the Put-to-Call ratios associated with both options trade volume (blue) and open interest (pink). Demand for call options dominated much of 2021, through til September, where bullish sentiment appears to wind down. As 2022 commenced, a distinct market preference emerged for put options, as more bearish sentiment took hold, and the demand for hedging downside risk increased.

Divergence in On-chain Volumes

Transitioning away from derivatives markets, we can see a similar trend of declining aggregate volume exists within on-chain settlement volumes. The Bitcoin network is currently settling between $5.5B and $7.0B in value per day, which is around 40% lower than the $9.5B to $11.0B/day seen at the bull market peaks.

Settlement volumes do however remain notably higher than the ~$2.0B/day seen throughout 2019-20, suggesting a net increase in network utilisation has occurred.

The breakdown of transaction size also appears to have structurally changed, most notably after October 2020. The chart below shows the relative breakdown of transaction volume by USD value, and the explosion of dominance for $10M+ transaction size (dark green) is quite clear. Prior to October 2020, these large size transactions barely accounted for 10% of transfer volume on a big day, however now reflect a fairly consistent 40% dominance.

Note that these charts utilise our entity-adjusted data, which filters out non-economic transactions such as exchange internal wallet management, and entity self-spends. It is likely that this sustained dominance of large transactions reflects a very real growth in value settlement by institutional sized investment/trading entities, custodians, and high net worth individuals.

Transfer volumes in and out of exchanges have always represented a significant share of overall transaction flows and are important to assess in context. The chart below shows the total entity-adjusted volume (blue), in comparison with exchange inflows (green) and outflows (red), all with a USD denomination.

Firstly, we can see that inflows and outflows are often quite similar in scale, with traces generally overlying each other, at least visually at this scale. Total exchange flows currently represent around $2.1B per day, with a slight dominance towards outflows ($1.1B/day vs inflows of $1.0B/day).

We can then take a ratio between total exchange flows (inflows + outflows), and total transfer volume, in an attempt to observe cyclical patterns associated with exchange transaction dominance.

Particularly since 2016, on-chain volume associated with exchange inflows/outflows generally increases during more speculative and bullish periods, such as the 2016-17 bull run, and again from July-2019 to May-2021.
Conversely, during later stage bear markets, such as 2018-19, and since May 2021, the share of exchange related activity generally declines relative to aggregate value settlement.

Volume in and out of exchanges currently represents between around 32% of all value settled, which is relatively low. This perhaps suggests there is a gradual transition away from pure speculation, and towards more fundamentally driven demand flows such as OTC transactions, HODLer accumulation, and custodial multi-signature setups etc.

Finally, we can take these observations of aggregate transaction volumes, and model them as a fundamental pricing model, via a methodology first proposed by Willy Woo. The NVT price model takes the 2-year median of the NVT Ratio, and multiplies it by current transaction volume. The resulting model thus establishes an implied valuation based on the current utilisation levels of Bitcoin for value settlement.

A 28-day (green) and 90-day (pink) period are used to establish a fast and slow signal respectively. These two models currently value Bitcoin between $32.5k (90-day) and $36.1k, with both starting to bottom out and potentially reverse. Of note is the recent positive momentum cross-over, with the faster 28-day breaking above the 90-day.

Historically, such cross-overs have been constructive medium to long term signals. However, as shown in blue below, these signals do require the confirmation of time to properly prove that positive momentum is in play. Greater value settlement on-chain would trigger both of these models to increase, implying stronger underlying fundamentals (and vice-versa is also true).

Summary and Conclusions

Bitcoin derivatives markets have matured significantly over recent years, and the underlying structure of them continues to evolve. We have seen a distinct shift in the preferred instrument away from calendar expiring futures, and towards perpetual swap markets, which is expected given the ease of price interpretation, and low storage and delivery costs of digital assets.

Over the course of the last 12-months, we have seen trade volumes, implied volatility, and available cash-and-carry yields compress to historical lows, which appears to be motivating some capital to leave the Bitcoin space in search of higher returns. With cash-and-carry yields persistently below 3.0%, and headline inflation running at 8.5%, this becomes increasingly probable.

Interestingly, despite on-chain settlement volumes being similarly muted, there is a growing (but early) trend of strength developing in underlying fundamentals. Transactions larger than $10M have sustained ~40% dominance since late 2020, and the dominance of speculative exchange inflows and outflows, often associated with bull markets, appears to be in decline.

Implied valuations of the NVT price model remain in the low to mid $30k region, which does indicate the bulls have their work cut out for them. However, these models are perhaps starting to bottom out and reverse, which is a trend worth keeping an eye on over the coming weeks.

Product Updates

All product updates, improvements and manual updates to metrics and data are recorded in our changelog for your reference.

Feature Release: Workbench Charts are now available in Dashboards, and all Dashboards now support full data history.

Released Options 25 Delta Skew Suite
Bug Fix: Fixed bybit related futures perpetual metrics. Previously we were not properly dividing these between futures and perpetual contracts.
Uncharted Newsletter Edition #13 released.

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