On-chain analysis may be a great addition to your cryptocurrency investing toolkit but it’s not without its limitations. We break down exactly what on-chain analysis is and whether you should consider using it as a strategy when building your portfolio.
Anyone that’s observed the cryptocurrency market will know that there’s a constant stream of conflicting news reports about the most popular coins, so it can be quite difficult to draw sound conclusions. Public sentiment seems to change regularly based on what we see in the news but oftentimes the stories that are published are just a glimpse of what’s really happening beneath the surface.
For that reason, on-chain analysis has gained popularity in recent years as analysts, investors, and traders look to adopt more robust evaluation methods. In this introduction to on-chain analysis, we’ll explain exactly what on-chain analysis is and some of the metrics that may be of interest to you when you’re looking into cryptocurrency.
What is on-chain analysis?
On-chain analysis is a research strategy that involves utilizing blockchain data. One of the most unique and revolutionary features of cryptocurrencies is that they operate on a blockchain which is essentially a public, digital ledger that records every transaction that happens on a network.
This form of analysis involves scrutinizing this transaction data and tracking activity to assess investor behavior, therefore enabling you to draw conclusions such as the market sentiment towards a cryptocurrency at a given point in time.
On-chain analysis was first popularised in 2011 when “Coin Days Destroyed (CDD)” was introduced to track activity on the Bitcoin network. CDD is a way of measuring the amount of Bitcoin that is sitting dormant on the network at a given time.
In 2017, Coin Metrics launched their Network Value-to-Transaction (NVT) ratio to value Bitcoin, taking into account its market capitalization as well as its usage based on transactions on the network. This brought attention to the utility of blockchain data for the purpose of strategic analysis.
Although it might sound like an extremely time-consuming task, you don’t need to scroll through transactions on a blockchain manually to perform on-chain analysis. There are a number of different websites that have aggregated transaction data to make it easier to analyze. Here are a few useful on-chain metrics that you can use:
This metric is particularly helpful for investigating new cryptocurrencies as it will give you an idea of a cryptocurrency’s spread of ownership. This is important to know because if a large proportion of a coin’s supply is owned by a small handful of wallets if one of them decides to sell, it could significantly impact the coin’s price.
For the biggest cryptocurrencies such as Bitcoin, Dogecoin, and Litecoin, you can check coin distribution on BitInfoCharts by looking at the ‘Rich List’.
Activity in cryptocurrency exchange wallets
On BitInfoCharts, you can also see which wallets are owned by cryptocurrency exchanges and the activity associated with these wallets. This is an important indicator because if a large volume of a cryptocurrency is moving into their wallets, that indicates that people are selling it. If a lot of cryptocurrency is moving out of their wallets, this indicates that people are ‘hodling’.
Cryptocurrency exchange balances
Another useful exchange metric is balances on exchanges. Similarly to the activity on exchanges, if the balance of a cryptocurrency on an exchange is low, it signals that investors are accumulating more of it. Two websites that are well-known for providing this information for Bitcoin are Glassnode (see the image below) and Cryptoquant.
For PoW cryptocurrencies, the hashrate is a measure of how much computing power is being contributed to the network by its miners. If we take Bitcoin as an example, a high hashrate would tell us that a high number of calculations are being done by Bitcoin miners per second. This indicates that more machines (or miners) are working to discover the winning computation so they can earn Bitcoin. A significant commitment of both time and expensive equipment is required to become a miner and if more individuals or companies are dedicating themselves to doing it, it’s a good indicator of the network’s strength.
Percentage of staked tokens
If you’re considering a cryptocurrency that uses proof-of-stake (PoS), looking at the percentage of its tokens that are staked is a useful way of evaluating investors’ commitment. Several cryptocurrencies have extended unstaking periods, which means that investors would have to wait days and often weeks to be able to access their tokens once they have been put into a staking pool.
If a high percentage of investors are willing to stake their cryptocurrency despite this, it implies that they intend to hold it long-term. You can find this information on individual cryptocurrency websites or on Staking Rewards.
Advantages of on-chain analysis
There are some clear benefits to performing this type of analysis:
Blockchain information is publicly available, easy to access, and relies on cold hard data, unlike technical analysis which requires a lot of guesswork to produce meaningful insights.
On-chain analysis is a great way for investors to leverage the repository of transaction data to make more informed decisions. It’s particularly useful for individuals who actively trade and want additional tools to improve their decision-making strategy.
On-chain analysis allows you to examine the underlying utility of an asset. Oftentimes, the price predictions we see in the news are based on nothing more than sheer speculation. But, by looking at metrics like exchange balances, you’re able to factor in possible indicators of an asset’s future value in real time.
Limitations of on-chain analysis
As powerful as this analysis method is, it’s not without its weaknesses:
On-chain analysis can only give a partial picture of what is happening on the blockchain. Nowadays, many transactions are completed off-chain. For example, Bitcoin’s Lightning Network introduced a second layer to the network, enabling some of its transactions to be completed off of the blockchain. This means that we’re no longer able to see all of the activity happening on the network in a single snapshot, making it increasingly difficult to conduct on-chain analysis in real-time.
Each metric can lead to a different conclusion about a cryptocurrency so you need to consider more than one metric when making a decision. The same applies to websites that display these metrics. Some are updated in real-time while others are only updated periodically, so you would need to look at a range of platforms when performing this type of analysis.
It’s easy to come to false conclusions based on on-chain analysis. If you don’t know what you’re doing you could end up misinterpreting a signal and losing out. For this reason, it’s best to use on-chain analysis only as a small part of a broader long-term investment strategy.
Should I use on-chain analysis?
Incorporating on-chain analysis into your investment plan can enable you to make more informed choices. That said, on-chain analysis is a relatively new field that has its limitations. If you choose to use this type of analysis, ensure that you’re evaluating more than one source and metric so you’re getting a well-rounded perspective.
As the cryptocurrency market continues to mature, it’s more than likely that analysis tools will become more robust as more data will be available to assist investors with decision-making.
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