The phenomenon of supply shock

Initiate
by Davide Dal Secco
16 December 2023

Index

The causes and consequences of the supply shock phenomenon on the price of Bitcoin and Ethereum can be observed through on-chain analysis.

In order to determine whether the bullish market for the cryptocurrency sector has already ended or not, it is worth evaluating, among numerous market indicators, the behavior of the two most capitalized assets in the sector: Bitcoin (BTC) and Ethereum (ETH), first and second respectively in Coinmarketcap’s ranking by capitalization.

1- How it is identified

Generally, a complete and comprehensive analysis of a cryptoasset should focus on 3 aspects: fundamental analysis or FA (Fundamental Analysis), technical analysis or TA (Technical Analysis), and on-chain analysis or BA (Blockchain Analysis). We will postpone the in-depth discussion of the differences between the 3 types of analysis to another article. In this article we will describe a phenomenon, supply shock, based on data extrapolated from the third type of analysis: the on-chain analysis.

In other words, “Blockchain Analysis” consists of the study of how coins are exchanged between market players over time through data provided by specialized providers, who aggregate the transactions made on the blockchain and represent them in the form of graphs or indicators to determine the market trend.


2- Supply-demand relationship and supply shocks

Price fluctuations that occur over a suitably long period of time are determined by the relationship between demand (demand) and supply (supply) in spot markets, while those in the short term are influenced by derivative markets. In this article we will focus on medium- to long-term fluctuations, which are the most reliable for understanding the value of an asset. Among the variables that determine the price of Bitcoin or Ethereum, the main one is the exchange of coins that takes place between buyers and sellers: according to one of the fundamental laws of economics, if there is an increase in the demand for an asset with the same supply, then the asset will increase in value, while, if demand remains stable and supply undergoes an increase, then that value will decrease.

In the cryptocurrency sector, this phenomenon, the supply shock, can occur in its most “extreme” form, from the perspective of price volatility. This phenomenon, also called a supply shock, which is certainly not new in economics and financial markets, usually occurs within a few weeks or a few months and arises when there is a meeting between a sudden and very intense increase in demand and a very small supply. The key factor is the scarcity of circulating supply. Supply shocks have occurred numerous times in Bitcoin’s history:

  • September 2017-December 2017, which resulted in a price increase of roughly 565 percent;
  • March 2019-June 2019, resulting in an increase of roughly 275%;
  • October 2020-April 2021, with an appreciation of roughly 500%.

It is no coincidence that these time intervals roughly coincide with Bitcoin’s halving.

The “motive” – if you can call it that – for the increase in demand consists in most cases from emotionalism, i.e.,euphoria andgreed, two sides of the same coin, of investors and speculators: many people inexperienced in investment and trading enter the crypto market for the first time hoping to make easy gains, as they have seen that there has been a rise in prices and believe that the trend will never reverse. Generally, the moment the sudden and intense increase in demand is realized, a speculative bubble is formed that is bound to burst after a short time.

It should be pointed out that these are never completely parabolic and uninterrupted price increases. Later on we will analyze the dynamics that characterized the last supply shock regarding Bitcoin and the situation of Ethereum, which, however, does not present such a large history when Bitcoin.


3- The data from the on-chain analysis

As reported at the beginning, on-chain analysis allows for a lot of valuable information for investors who want to know how coins are moving among the players in the market. In order to give a satisfactory (but not definitive) answer, it is sufficient to consult the charts of two major on-chain information providers: CryptoQuant (www.crytoquant.com) and Glassnode (www.glassnode.com). In addition, there are some on-chain analysts who disseminate their analysis via Twitter and through other platforms, such as YouTube.

Of course, this analysis is based on the spot market, but in some cases the derivatives market, particularly the perpetual futures market, takes over, further increasing the volatility, which itself very high by traditional finance standards, of crypto prices. Events such as a substantial de-leveraging, caused by a black swan, a change in monetary policy, or the entry into recession in a very financially influential country, such as the United States, can delay, mitigate, cancel, or even reverse the effects of a supply shock.

Below we illustrate graphs showing the price and reserve behavior of Bitcoin and Ethereum coins in major centralized brokers or exchanges as of September 2020.

3.1 Bitcoin (BTC)

Regarding Bitcoin, this tool, called “BTC: AllExchangeReserve” (“BTC: All Reserves in Exchanges), tracks the number of coins in investors’ wallets connected to centralized exchanges (Centralized Exchanges or cex) at the aggregate level. The black line shows the price trend from September 2020 through September 2021 and the blue line the number of bitcoins in those wallets.

During bitcoin’s 2020-2021 bull market, 4 macro-trends can be highlighted that characterized its supply:

  1. It can be clearly seen that until November 2020, the number of bitcoin pieces in the cex was steadily decreasing, following a period of strong accumulation that lasted for several months, so the supply shock occurred and there was a considerable increase in the price from November 2020 to early January 2021: roughly from $12,000 to $42,000.
  2. The period from January 2021 to the end of April 2021 was characterized by the meeting of supply and demand, in which investors, who had bought and withdrawn bitcoins from the exchanges until January 2021, had then deposited and sold them in a price range of $50,000 to $60,000, so a distributional phase materialized: the net between coin outflows and inflows in the exchanges had in fact been almost zero.
  3. From the last days of April 2021 and throughout May 2021, a period of very large inflows occurred, as a result of which an increase in bitcoin reserves in the centralized exchanges can be seen in the graph, which caused a sharp downward price correction.
  4. From June 2021, although not consistently and evenly, until mid-September 2021 the supply trend was very definite: hundreds of thousands of bitcoins were and still are being withdrawn from the cex and thus removed from the available or circulating supply.

Investors are assumed to want to sell their coins if they deposit them in centralized exchanges, although theoretically they could be deposited without necessarily and immediately being liquidated. If, on the other hand, coins are transferred to a wallet other than the cex wallet, then one is necessarily certain that the purchase has taken place and that the circulating supply has decreased. For example, if you purchase 1 BTC or 1 ETH from Coinbase and transfer it to your Ledger Nano S, then the supply of coins available for purchase is reduced and this information is reported in the CryptoQuant tool above.

3.2 Ethereum (ETH)

Let us now turn to the situation of the circulating supply of Ethereum by analyzing the tool analogous to that used for Bitcoin.

As is evident from the graph, the trend by which ETHs are being picked up by exchanges is more pronounced and simultaneously easier to study than that of Bitcoin. With the exception of a small spike (sudden and isolated increase) in the supply of Ethereum in early June 2021, it is blatant that the supply of ether available in the exchanges has been steadily decreasing, regardless of the period considered.

It is important to point out that ethers have more use cases than bitcoins: one example out of all, ethers are needed to purchase an NTF in the Ethereum network, while in the Bitcoin network this cannot be done; therefore, it is not surprising that the demand for ethers is more substantial than for bitcoins.


4- Conclusions

The data that can be obtained from the on-chain analysis is a valuable source of information for an investor who invests in the medium- to long-term and wants to know the moves of other market players, as well as of the supply-demand relationship of a cryptocurrency.

As seen from the on-chain situation, it is clear that a considerable amount of bitcoin and ether have been withdrawn from the centralized exchanges over the previous months, and unless there is a “black swan event” in the markets (e.g., the crash caused by Covid in March 2020) or a radical change in the world economy, the trend does not seem to have any intention of reversing at the time of the tapping. Not surprisingly, it is frequently said, “The trend is your friend until the end.”

Assuming that the bull run continues, the most logical projection would be to reach a new equilibrium price, much higher than the current one, such that it will not seem at all strange to observe significant inflows of coins into the exchanges in order to realize profits, just as it happened in the cases of previous supply shocks.

Author: Davide Dal Secco

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