The Week On-chain Newsletter

A Coiled Spring

The Bitcoin market is primed for volatility, with both realized and options implied volatility falling to historical lows. Futures open interest has hit new all-time-highs, despite liquidations being at all-time-lows. Volatility is likely on the horizon, and Bitcoin prices rarely sit still for long.

Checkmate, UkuriaOC, Glassnode

Oct 17, 2022 • 9 min read

Bitcoin markets continue to consolidate into a a tight price range, with almost all of the extreme prices of the weekly range reached during a 24hr window. In response to US inflation data coming in slightly hotter than expectations, BTC prices traded down to $18,338, followed by a quick rally to a high of $19,855, before completing a round trip to the weekly open price.

In this weeks edition, we will explore how the Bitcoin market is currently in a period of historically low volatility, and with many metrics both on, and off-chain signalling a period of elevated volatility is likely ahead. Historical precedents in bear markets have broken out from such market structure in both directions, with little directional bias evident in futures markets pricing.

🔔 Alert Ideas are presented throughout to help identify key metric levels of interest that may signify significant shifts in market/network performance. Any Glassnode member can set an alert directly from Glassnode Studio.

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Volatility is Imminent

It is very uncommon for BTC markets to reach periods of such low realized volatility, with almost all prior instances preceding a highly volatile move. Historical examples with 1-week rolling volatility below the current value of 28% in a bear market have preceded significant price moves in both directions 🟦.

A similar compression can be seen within the aSOPR metric which measures an average realized profit/loss multiple for spent coins on any given day.

aSOPR of 1.0 in a bullish trend often acts as support, as market participants tend to increase their position at their cost basis, manifesting as buying the dip.
aSOPR of 1.0 in a bearish trend often acts as resistance, as investors seek exit liquidity around their cost basis, with investors seeking any available exit liquidity.

A large divergence is currently forming between price action, and the aSOPR metric. As prices trade sideways or decline, the magnitude of losses that being locked in are diminishing, indicating an exhaustion of sellers within the current price range.

As the weekly average of aSOPR approaches the break-even value of 1.0 from below, it is increasingly likely that volatility is on the horizon, either as a breakout, or yet another rejection.

🔔 Alert Idea: aSOPR (7D-SMA) breaking above 1.0 could signal an improvement in market profitability, and is an early signal of a potential market recovery.

Inspecting the aSOPR metric by constituent investor cohorts, we can isolate the contribution of the Short-Term (STHs) and Long-Term Holders (LTHs). We will start with the STH class, where we can identify two similar cases in history:

The 2015-2016 Bear Market 🟢 experienced a divergence between price and STH-SOPR. This divergence was confirmed with a STH-SOPR breakout above 1.0, followed by several supportive retests of the level. This indicates a psychological switch from securing exit liquidity, to buying the dip near the cohort cost basis.
The 2018-2019 Bear Market 🔴 also experienced a divergence between price action and spent profitability, however, this culminated as a rejection from the break-even level as participants overwhelmed demand, and sought exit liquidity at their cost basis.

Currently, STH-SOPR is approaching a break-even threshold once again, with the most recent attempt in August failing to sustain a break higher.

🔔 Alert Idea: STH-SOPR (7D-SMA) breaking above 1.0 could signal an improvement in market profitability, and is an early signal of a potential market recovery.

By comparing the monthly spending patterns of the STH cohort to their yearly baseline, we can establish whether a macro momentum shift in profitability regime is occurring.

Where Monthly Growth > Yearly Growth 🟢 STHs are realizing more profits of late, which increases the probability of a constructive reversal.
Where Monthly Growth < Yearly Growth 🔴 STHs are realizing more losses of late, indicating that seller exhaustion has not been reached, and increases the probability of a STH-SOPR rejection at breakeven.

The STH-SOPR multiple is attempting its fifth breakout of this bear cycle, battling for a shift in momentum. Each prior attempt was met with rejection, and a subsequent decline in prices. However, the severity of drawdowns in the STH-SOPR multiple are diminishing with time, reflecting increasing likelihood that seller exhaustion is occurring.

Conversely, Long-Term Holder spent profitability continues to languish at historical lows, with this investor cohort locking in losses of around -48% on average. With price remaining remarkably stable of late, it is evident that the main transactors from the Long-Term Holder cohort are those from the 2021-2022 cycle, who continue to capitulate their positions at a loss.

These periods of extreme LTH profitability stress generally occur towards the depths of the bear market with only 3.3% 🟣 of trading days incurring higher losses.

🔔 Alert Idea: LTH-SOPR (7D-SMA) breaking below 0.50 could indicate a further flush out of the LTH cohort, with less than 3% of trading days seeing larger average LTH losses.

Off-Chain Volatility Brews

In the off-chain domain, volatility is also brewing in the derivatives markets. Options pricing of short-term implied volatility (IV) has reached an all-time-low of 48% this week. Several prior instances of such low IV has preceded violent moves, often compounded by the de-leveraging of derivatives and DeFi markets.

Trading volumes in futures markets have also declined to multi-year lows of $24B per day. This returns to levels last seen in December 2020, before the bull cycle had broken through the 2017 cycle $20k ATH. This may signal a lower liquidity trading environment should the market find momentum in either direction.

We have also seen an aggressive, and consistent increase in Futures Open Interest since the collapse of the LUNA-UST project. BTC denominated futures Open Interest has reached a new ATH of 633k BTC, which is an 80% increase since May this year.

This suggests that levels of speculation, and/or hedging positions are increasing, despite coin prices declining significantly over this time.

Thereafter, we can assess the Futures Estimated Leverage Ratio to investigate the relative scale of open contracts compared to the balance of BTC reserves held across all major exchanges. We can similarly observe the remarkable growth in futures open interest relative to the BTC balance on exchanges.

This provides another indication that a somewhat low liquidity environment is in play, and could result in an elevated impact on spot markets should some of this leverage unwind.

Another metric we can use to assess the health of futures markets is the proportion of positions using Crypto or Cash as margin.

Crypto-margined collateral such as BTC or ETH is inherently more volatile, as fluctuations in the value of underlying collateral can amplify deleveraging events.
Cash-margined collateral such fiat or stablecoins effectively hold 1-1 with the dollar, and do not fluctuate in value alongside the open futures position.

Using this framework, we can observe the evolution of market preference over time:

The peak dominance of Crypto-Margined collateral reached 70%, and marked the height of exuberance in April 2021. This was followed by a major decline in digital asset prices.
A regime switch occurred after the May 2021 sell-off, with Cash-margined collateral becoming the dominant choice, causing crypto-margin dominance to fall to 35% today.

Cash-margined collateral dominance reached an ATH this week, indicating that the vast majority of the new open interest, are cash margined positions. As such, the health of the derivative collateral structure has vastly improved over the last 18-months. This acts to reduce the probability of an amplified liquidation cascade, whilst also demonstrating the growing market demand for stablecoin collateral.

During the exuberant speculation seen around Feb to Apr 2021, the futures cash-and-carry trade was yielding between +45%/yr and +100%/yr for rolling 3-month contracts, and perpetual futures, respectively.

This has declined dramatically ever since the May 2021 sell-off, with both the the rolling 3-month basis (0.55%/yr) and perpetual funding rates (1.97%/yr) now trading at negligible yields, especially relative to prevailing rates for many sovereign bonds. Both annualized funding rates and annualized rolling basis also briefly entered backwardation in late August.

Despite challenging price conditions, and a persistent increase in futures open interest, there remains no notable directional bias within the current futures positioning. This increases the chances that much of this leverage is may be utilized for the hedging of risk, rather than directional speculation.

Following this, we can assess the total Long and Short liquidations as a percentage of total Open Interest across all futures contracts. This provides insight into the proportion of open interest cleared via liquidations, rather than discretionary position closes.

Total liquidations are now historically low, hitting just 0.1% of total open interest, which is somewhat counter-intuitive given the marked increase in futures positions and leverage. Long positions 🟢 remain the dominant liquidated position, however only by a small margin, with 54% of liquidations being longs this week.

Overall, this set of derivatives market observations likely suggests a more sophisticated set of risk hedging positions are prevalent in the current market. These positions likely treat Bitcoin as a high beta asset in both the instance of severe drawdown, or in the case of a volatile break higher, and are thus less sensitive to directional pricing.

This is based on the persistent decline in crypto-margin dominance, near uninterrupted increase in open interest as prices fall, but accompanied by historically low liquidation volumes, and almost no directional bias in cash-and-carry yields. We can also note that almost the exact opposite set of conditions was prevalent at the April 2021 ATH, which we have argued was the true end of the 2021 Bitcoin bull market.

Summary and Conclusions

The Bitcoin market is primed for volatility, with both realized and options implied volatility falling to historical lows. On-chain spending behavior is compressing into a decision point, where spot prices intersect with the Short-Term Holder cost basis.

Previous instances where this set of conditions was prevalent have preceded violent price moves, with examples in previous bear cycles being in both directions. There remains little discernible directional bias in futures markets, despite open interest pushing to new ATHs.

Volatility is likely on the horizon, and Bitcoin prices are not known to sit still for very long.

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