Realized Cap Highlights Continued Outflows
Realized capitalization is an important metric we have frequently referenced in prior notes. It values the network based on the price at which each bitcoin was last exchanged. It is a way to calculate the overall cost basis of all $BTC holders and, consequently, is a useful measure of flows into and out of the bitcoin network.
As one might expect, this year has witnessed significant and sustained declines in realized cap as entities that bought towards the market top of the market in 2021 have sold their BTC at a loss, seeking liquidity in other assets. Below we include the 30-day average of the realized P&L metric, which calculates the aggregate gain/loss on bitcoin transactions. When realized P&L moves below zero, we can see that realized cap heads lower.
Below is a more explicit graphical representation of the same realized cap metric. This chart articulates the same observed outflow trend differently – mapping out inflows/outflows on a weekly basis. Understandably, there have been sustained outflows since Q2 of this year.
A couple of things to note on the chart above:
- Naturally, most cycles are comprised of a period of outsized inflows followed by outflows. However, using the 2017 bull market as the most recent precedent, we can see that outflows often stop well short of equaling the inflows of the preceding bull run. We would expect the same dynamic following the bull market of 2021.
- While outflows have been persistent, the aggregate outflow in recent weeks is less significant than the exodus witnessed over the summer months. This could mean that the more recent outflows may be from entities that bought this year at a comparatively lower cost basis, meaning we are witnessing the final leg of capitulation.
On a relative basis, the current drawdown lines up quite well with drawdowns in prior cycles. Below is a new version of the chart we shared last week, which displays historical price drawdowns from ATH. Overlayed this week are historical drawdowns in realized cap. The current drawdown of over 20% is in line with the peak drawdowns in prior cycles.
Viewing bitcoin through the lens of a store of value, realized cap is arguably the most essential on-chain metric to monitor since it is a literal measure of the amount of capital stored/removed from the network. Thus, it is easy to ascertain why we likely need to see realized cap move conclusively higher before we can be confident in sustained bullish price action.
However, one interesting thing to note on realized cap is that it can continue to decline after price has put in a cycle low. The red lines above indicate historical lows for BTC price, while the yellow lines demonstrate the cyclical lows in realized cap.
The unscientific explanation here is that at some point, bitcoin will consolidate and move slightly higher during a period of low volatility (Kind of what we are seeing now). This period should witness a cohort of long-term buyers who create a formidable buy wall. While coins purchased at higher levels continue to capitulate and realize losses, the bids from higher-conviction buyers start to increase incrementally over time.
To summarize the takeaways as they pertain to realized cap:
- A persistent decline in realized cap indicates continued outflows from the bitcoin network in 2022.
- On a relative basis, the current drawdown in realized cap lines up with historical cyclical drawdowns.
- It is essential to see this metric climb before we can be confident in a sustainable bull market trend.
- A declining realized cap does not necessarily preclude bitcoin’s price from bottoming and trading incrementally higher. Historical patterns demonstrate this dynamic.
Ethereum Users Continue to Migrate to L2
Mainnet Activity Declining
Shifting our focus to the Ethereum network, we see that on-chain activity continues to decline from the euphoric levels achieved towards the middle of 2021. We saw a spike in activity around the Merge this year, but overall, the trend has decreased for most of this year.
Scaling on L2
Looking a little more closely underneath the hood, however, the underlying trends on L2s paint a rather promising picture as it pertains to the future of the network. Yes, some stablecoins and higher-valued items, such as 1-of-1 digital art, will continue transacting on Ethereum Mainnet. For those items, you want to be as close to the security offered by Mainnet as possible. However, the long-term path forward for Ethereum continues to be a modular path that scales in layers. Now that we are beyond the Merge, the next significant network initiative (beyond allowing stakers to exit the Beacon Chain) is EIP-4844. This network upgrade primarily aims to introduce the concept of proto-danksharding. We will not wade into any technical details in this note, but the general goal of proto-danksharding is to enhance the scalability of layer-2 rollups.
With this initiative on the roadmap, we have seen an incredible amount of development effort on Ethereum L2 over the previous 12 months. We have previously discussed the impressive activity on Arbitrum and the opportunity the network presents for airdrop farming. We have also highlighted the strides made by the Optimism ($OP) team in the past.
Below we see that activity on these two L2 networks has increased impressively in the second half of this year, with both nearing the transaction figures on Mainnet.
To put the respective activity levels into perspective, we can chart the aggregate number of transactions on Optimism and Arbitrum as a ratio of the number of transactions on the Ethereum mainnet.
The results indicate that this ratio is quickly trending towards 100%, meaning the transaction activity on the two leading layer 2 networks is roughly equivalent to the activity taking place on mainnet.
While the implications of increased L2 activity on ETH price require a more complex analysis (for instance, how much activity is migrating from L1 to L2 vs. how much activity novel to L2s is enabled), this is, at the very least, a clear sign that the Ethereum network is executing on its long-term scaling goals.
Application-Level Trends Enabled by L2
The early traction on L2s also offers a glimpse into the types of applications we might see garner more attention soon. In recent weeks, two of the more popular applications on Arbitrum have been GMX ($GMX) and Treasure ($MAGIC). The former is an exchange for decentralized perpetual futures contracts (“perps”), and the latter is a decentralized gaming console. These two thriving apps serve as a window into two application types that stand to benefit from increased L2 adoption.
First, let’s address the recent GMX traction. Below we see the increasing open interest on GMX throughout the bear market. FTX garnered a significant share of centralized markets’ overall perps trading volume. Following FTX’s recent demise, it became apparent that there is indeed a market for usable on-chain DeFi primitives that allow users to trade spot, perps, and options in a decentralized and transparent manner. However, it has been proven that for derivatives markets, the costs incurred on Ethereum L1 are far too high for any market participants trading frequently or in size. However, these types of applications are ideally suited for high-throughput layer 2s.
Thus, it is reasonable to think that the recent traction for GMX will continue throughout this bear market and into the next cycle, given the inherent demand for this type of product and the newfound ability to transact in this manner on top of Ethereum (albeit on an L2). Whether the liquidity will continue migrating to GMX, specifically, remains to be seen. Regardless, there will likely be continued demand for derivatives products on Arbitrum and other scalable L2s due to tailwinds from the emergence of L2s as well as the embedded risks of trading derivatives at centralized, unregulated venues.
Just as derivatives trading applications are not necessarily suitable for Ethereum mainnet, neither are most NFT-enabled games. These games often necessitate frequent transactions on-chain, requiring the minting, purchasing, and exchanging of in-game items to function correctly. This is expensive on mainnet and results in poor UX for users.
This is the major reason why Treasure DAO, the operating organization behind Treasure, has migrated its product to Arbitrum, where the majority of activity now occurs. Treasure aims to become an ecosystem of games, all connected via the native Treasure token (MAGIC). As we can see below, since the industry-wide drawdown over the summer, the MAGIC token on Arbitrum has increased its user base significantly.
The chart below maps the total NFT transactions per week on Arbitrum. NFT adoption has increased steadily since Q2 of this year, likely driven by the ability to mint and cost-effectively transact non-fungible items. This highlights the significant tailwind for crypto gaming that L2 adoption presents and is why this is poised to be a core theme that intrigues us in the coming months.
Volatility Looking Cheap Ahead of CPI Print
While our heads remain on a joint swivel looking for any more idiosyncratic risks within crypto, we must remember that next week is the final CPI print and rate increase before year-end.
Interestingly, we can see below that implied volatilities have fallen off a cliff after the dramatic spike in early November following the FTX-induced chaos. Weekly, 1-month, 3-month, and 6-month implied volatilities are now at approximately the same levels as they were leading up to the FTX implosion.
Our view remains that the immediate-term opportunity in the crypto market does not outweigh the embedded macro and industry-specific risks. However, given the rapid decline in volatility over the past few weeks, it could be an excellent opportunity to be long volatility ahead of what could be an eventful week for both crypto and traditional financial markets.