Imagine you're tracking the price of Bitcoin and suddenly see a perfect opportunity to buy. You jump on the exchange, do your analysis using Bitcoin indicators, place your order, and wait... and wait. If you’re lucky, your order will fill quickly, and you’ll get the price you saw. But if the network is congested, your order might fill at a much different price, or even worse, the price could change before your transaction clears and your order fills. This scenario illustrates why understanding the difference between on-chain and off-chain transactions is important for Bitcoin investors. While on-chain transactions are processed directly on the blockchain and can be slow and costly during congestion, off-chain transactions are settled instantly between parties outside the blockchain. In this article, we'll break down the advantages and tradeoffs of both systems to help you make informed decisions for your Bitcoin investments.
Bitcoin Magazine Pro's Bitcoin Analysis tool can help you quickly understand the current on-chain vs. off-chain dynamics to make smart trading decisions that maximize your profits and minimize risk.
What are Bitcoin on Chain Transactions?
Bitcoin uses a blockchain as a ledger to record all transactions. All Bitcoin can be found somewhere on the blockchain, and all Bitcoin transactions recorded on the blockchain are considered on-chain transactions.
How Do On-Chain Transactions Work?
On-chain transactions operate directly on the blockchain. When you send Bitcoin to someone, you’re not sending the digital currency itself. Instead, you’re signing over ownership of the Bitcoin to the recipient’s address. This process is akin to changing the name on a car title. When you make an on-chain transaction, the blockchain updates to reflect that you now have less bitcoin, and the recipient has more.
All on-chain transactions must pay a fee to be included in a block. The higher the cost, the faster the transaction will be confirmed. To execute an on-chain transaction, you must own Bitcoin on the blockchain. This bitcoin will be locked in an address, and, using the private key corresponding to that address, you can sign a transaction sending this bitcoin to a new address.
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On Chain vs. Off Chain Transaction Tradeoffs
On-chain transactions, as the name suggests, occur on the blockchain. When you send Bitcoin to someone, the transaction details include the:
- Sender
- Receiver
- Amount
Are recorded on the blockchain. Every on-chain transaction is time-stamped, and based on the blockchain network’s consensus technique (such as Proof-of-Work or Proof-of-Stake), the blockchain network’s computers (or nodes) validate these transactions.
Verifying transactions and adding new blocks to the chain can use significant processing resources in PoW blockchain networks. The intense energy needed severely pollutes the environment and hastens global warming.
Off-Chain Transactions: The Basics
Off-chain transactions take place outside of the blockchain. Instead of recording every little detail on the blockchain, these transactions occur using typical third-party guarantors and layer-2 solutions (which try to address the scalability difficulties present in the blockchain) specifically created to lessen the pressure on the primary blockchain. The Liquid Network and the Lightning Network are two examples of those solutions.
Transparency and Security
On-chain transactions are extremely secure and transparent since they are time-stamped and recorded, making it impossible for anyone to change or undo them. Off-chain transactions have varying levels of security depending on how they are carried out. Involved parties will establish a side channel utilizing a layer-2 solution (such as the Lightning Network).
Once the transaction is finished, the side channel will be closed, allowing the main blockchain to record it. Other off-chain transactions might not leave a trace behind to help either party involved in the transaction in case of a dispute.
Bitcoin Lightning Network
On-chain transactions provide a higher level of openness, but anonymity suffers. Thanks to the transaction patterns, it is possible to partially identify the people involved because the specifics of on-chain transactions are safely stored inside a publicly distributed ledger.
Off-chain transactions offer greater anonymity because they aren’t visible to everyone. Even off-chain transactions with layer-2 solutions, which may leave a trace on the main chain, are encrypted and unavailable until the chain is closed, maintaining the parties’ confidentiality.
Comparing On-Chain vs Off-Chain Transaction
Each of these Bitcoin transactions has distinct advantages and drawbacks. On-chain transactions are best for high-value transfers or situations where security and transparency are crucial. They provide high trust because they are recorded on a public ledger.
Off-chain transactions are ideal for everyday transactions, especially when speed and cost are more important than transparency. They are great for small payments or situations where privacy is a priority.
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What is Chain Analysis & Why is It Important?
On-chain analysis looks at the data stored on the Bitcoin blockchain to understand market dynamics and human behavior. It offers investors unique insights into the Bitcoin market that can help them navigate volatility.
Bitcoin on-chain data provides analysts a degree of X-ray vision into market behavior, offering powerful tools and insights into investor behavior that traditional finance can only dream of. “Put all your eggs in one basket, and then watch that basket.” Andrew Carnegie.
A Unique Asset Shaped by Voluntary Participation
Bitcoin is unique and undoubtedly one of human history's most loved, hated, feared, and revered assets. Its meteoric bulls, depressing bears, and one-of-a-kind value proposition have attracted holders and speculators from around the globe, bringing with them all manner of backgrounds and life experiences.
Most importantly, it is an opt-in system, meaning almost every decision and action by Bitcoin holders on-chain is voluntary.
Navigating Bitcoin’s Markets Through the Ledger
At the center of Bitcoin's uniqueness is the organic nature of its ledger, immutably recording who owned what, for how long, and when (the UTXO set). Given the wild volatility of Bitcoin’s price, its ledger offers a unique lens into the full range of human incentives, emotions, decisions, and psychology about markets, fear, and greed.
Over the last six years, a fascinating new analysis discipline has developed for Bitcoin. This discipline focuses on extracting key market information from the Bitcoin ledger. This article will explore some of the most powerful concepts in the field of on-chain analysis and demonstrate just a few insights that help investors and traders confidently navigate Bitcoin’s volatile markets.
What is Bitcoin On-Chain Analysis?
Big data, machine learning and data analysis have become a multi-billion dollar industry, and companies of all sizes leverage it to find opportunities within data sets and none more so than financial markets. The issue with big data is that you need a constant flow of reliable information to feed your models and adjust them accordingly.
While data integrity remains an issue for centralized services, Bitcoin and its data, secured on a public blockchain, make it uniquely well suited for data science and machine learning, naturally birthing the field of on-chain analytics.
Key Metrics in On-Chain Data Analysis for Bitcoin and Blockchain
The study examines Bitcoin and blockchain data fundamentals and their utility and transaction activity. In on-chain data mining, analysts analyze various metrics to improve their understanding of network movements.
Some of the most common types of analysis include transaction volumes, block details, price correlation, transaction sizes, transaction fees, mempool clearing times, exchange inflows and outflows, user adoption, and more. We'll examine the most popular metrics and reports to give you an idea of the subsets of data chain analytics firms' track and process.
On-Chain Analysis to Measure The Network Strength
The following metrics give investors and traders an overview of the network, including how secure it is, how much it is being used, and how its monetary policy functions.
These metrics gauge the network's usage, whether that usage is growing, and by how much.
Active Addresses
Active addresses show the number of active addresses on the network. While it doesn’t show exactly how many users there are on a network, it shows the number of addresses used by exchanges, miners, and individuals. Historically, active addresses have correlated with price.
Transaction Volume
Transaction volume represents the fiat (usually in US dollars) amount of a Bitcoin exchanged between addresses.
Daily Issuance
Daily issuance is the total number of new coins miners are awarded daily. This is a look at Bitcoin's monetary policy and whether it is functioning correctly. Coupling daily issuance with the supply halving roughly every four years is all part of Bitcoin’s promise to ensure a fixed supply of 21 million coins.
Supply Distribution
Supply distribution shows the percentage of coins held in addresses categorized by size. For example, addresses holding more than ten thousand Bitcoin have decreased over the past few years, as compared to addresses holding less than ten Bitcoin have increased. While we start to see it addressed with less than one Bitcoin, it grows faster than ever.
5. Miner Revenue
Miner revenue is the sum of newly mined Bitcoin plus transaction fees. High revenues reflect a healthy network where miners are incentivized to protect the network's long-term interests. Miner revenue can also be matched with current trading prices to show traders how profitable miners can be and whether it’s worth investing in Bitcoin mining stocks.
6. Hash Rate
Hash rate measures the amount of processing power that miners generate to secure the
network. Overall, the higher the hash rate, the more secure it is.
On-Chain Analysis To See Who’s Buying And Selling
While the on-chain indicators above represent the network's long-term health, the following indicators reflect short, to mid-term market action, specifically focusing on the amount held by miners, exchanges, and individuals.
It also shows whether they’re in profit or are currently at a loss, telling traders and analysts the cost basis for entry into the market.
1. Coin Time Destroyed
Coin time destroyed is calculated by taking the number of coins transacted in a day and
multiplying them by the time they were previously held. In essence, it shows us a turnover time. An increase in coin time destroyed implies that holders are moving coins out of storage and taking profits.
2. Realized Profits And Losses
Realized profits and losses measure the dollar value of Bitcoins sold at either a profit or loss. For example, if a coin was purchased for $10k and sold for $50k, that’s a $40k profit.
3. Supply In Profits And Loss
Supply in profits and loss shows the number of coins currently in profit or loss compared to their last purchase price. In a growing market, more coins will be in profit than loss.
4. Realized Capitalisation
Realized capitalization adds the most recent purchase price of every Bitcoin in supply. Compare this to market capitalization, the number of coins multiplied by the current price. When the realized cap is higher than the market cap, the overall market is profitable.
5. Thermo Capitalisation
Thermo capitalization is the dollar value of the digital currency paid to miners to validate the network. Compared to the market cap, the decreasing thermo cap over time shows that the supply pressures from miners are declining and having less of an impact on the price.
6. HODL Waves
The term ‘hodl’ is an endearing and popular term for Bitcoin investors who hold their coins for the long term rather than trading them. HODL waves illustrate the percentage of Bitcoin held for different periods, from less than one month to more than seven years. For example, the amount of coins held for more than seven years has grown considerably, showing that ‘hodlers’ control a growing portion of the network.
On-Chain Metrics To Evaluate Price
Those who plan to trade Bitcoin frequently use on-chain analysis to gauge the market’s sentiment. They want to know exactly what’s happening via the chain and centralized exchange markets.
Comparing the flow of funds on the chain and that into the wallets of exchanges, certain traders can determine if it’s a good time to be aggressive or cautious and allocate to positions accordingly. Reviewing metrics for trading following ratios can help give you an idea of the short-term trends in the market.
Market Value To Realised Value (MVRV)
Market Value to Realised Value (MVRV) is the ratio between market capitalization and realized capitalization. For example, a high MVRV for Bitcoin has historically signaled its price near a local maximum. In contrast, a low ratio has indicated that the price is near a local minimum.
Network Value To Transaction (NVT)
The Network value-to-transaction ratio compares the market cap to the transaction volume. In the Bitcoin space, it’s often compared to an approximation of the price-to-earnings ratio used in traditional finance.
It aims to compare the network's fundamental value to its current price. A low NVT shows a bearish sentiment, while a high NVT signals a bullish sentiment.
Stock-To-Flow Ratio
The stock-to-flow ratio (S2F) is a model that predicts Bitcoin's price if its demand continues growing at the same pace. The S2F model doesn’t take into account any unknowns and merely tries to apply today’s demand extrapolated out into the future. Because of the way it calculates potential price movements into the future, the S2F model has been paraded as a gimmick to drive bullish sentiment.
Which Companies Do Chain Analysis?
According to Blockdata, there are over 100 chain analysis and research firms in operation, some specializing in Bitcoin, while others tend to include other blockchain networks. Some chain analysis firms offer B2C packages, and many of these on-chain analytics platforms are either free or at least offer plenty of free features. Most of them focus on B2B customers, like exchanges, financial institutions, online media publications, and even governments, who require this data for compliance or research purposes.
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Why is Combining On And Off-Chain Analysis Necessary?
Bitcoin on-chain analysis refers to transactions that occur on the Bitcoin blockchain. Each Bitcoin transaction creates a permanent record on the blockchain that is publicly accessible and immutable. This data can be analyzed to track Bitcoin's movement, understand market sentiment, and even identify the parties involved in a transaction.
On-chain analysis can reveal necessary information about the current health of the Bitcoin network and the state of the asset’s market. Off-chain Bitcoin analysis evaluates trades and transfers that occur off the blockchain. Off-chain transactions typically occur within or between exchanges and other market participants. Like on-chain analysis, off-chain Bitcoin analysis serves multiple purposes, including:
- Monitoring illicit activity
- Tracking market trends
- Informing trading decisions
Why is Combining On-chain and Off-chain Analysis Necessary?
Many situations call for analysts to synthesize on and off-chain data. For example, U.S. Securities and Exchange Commission investigators linked off-chain token listing announcements to on-chain DEX trades to convict a former Coinbase employee of insider trading.
On-Chain Analysis in Financial Regulation
Examiners at the New York Department of Financial Services (NYDFS) have also begun performing this type of monitoring. Another example can be found in digital currency investigations. When a criminal investigator identifies a pattern of suspicious transactions, they can use on-chain analysis to determine whether the entities involved have later (or previously) transacted with a regulated exchange.
Applications of On-Chain Analysis
If the agent finds an exchange connection, they can subpoena that organization to gather off-chain know-your-customer information. This process also works in reverse; a compliance professional can use on-chain analytics to identify suspicious transactions initiated by a customer on-chain. Then, they use official reporting mechanisms to provide off-chain information to their regulators.
Technical Analysis vs. On-Chain Analysis vs. Fundamental Analysis
Understanding the Types of Bitcoin Analysis: On-Chain Analysis, Technical Analysis, and Fundamental Analysis
Bitcoin analysis can be performed in several ways, including on-chain, technical, and fundamental. All three methods analyze different data points and provide unique insights into market conditions. Understanding how each method works can help you formulate a more effective trading strategy.
Fundamental Analysis
Fundamental analysis strives to understand an asset by factoring in multiple aspects, like its market capitalization, trading volume, utility, the number of holders, and the authenticity of the team behind it. This analysis is necessary to establish whether an asset is overvalued or undervalued. Here is an example of a simple fundamental analysis of Bitcoin (BTC).
BTC has a maximum supply of 21 million coins, and 19.3 million are already in circulation. This implies that only 1.7 million bitcoins are left to be added to circulation, driving the scarcity of BTC. According to the laws of demand and supply, the more scarce an asset is, the more value it gains. These details are part of the fundamental analysis you can use to make a wise investment decision.
Technical Analysis
Technical analysis uses data from previous performances to forecast possible market performances. Technical and fundamental analysis factor in various price aspects. Fundamental analysis derives price movements from economic activities, fundamental releases, and geopolitical events. Technical analysis focuses primarily on:
- Past activities
- Price movements
- Trading activity
Let’s use the price movement of BTC from November 2020 to July 2021 to show how technical analysis works. The chart above exemplifies a head and shoulder pattern, a potential price movement reversal pattern where any breakout from the neckline signals a major price change. The price of BTC fell from $50,000 to almost $35,000 when it broke below the neckline on 15th May 2021. Check out our articles on long-wick candles and higher highs to learn more about technical analysis.
On-Chain Analysis
On-chain analysis considers verified and recorded data on the blockchain to predict trends and gauge market sentiment. In other words, on-chain research involves monitoring how funds move on the blockchain to detect potential investment opportunities. You can conduct an on-chain analysis to determine why various market participants buy or sell a given asset. Below is an example.
Through an on-chain analysis platform like Glassnode, you can view various BTC investors' activities. They may actively deposit assets in centralized exchanges (CEXs) or withdraw them to decentralized wallets. A high inflow to CEXs suggests the chance that they will dump their holdings, while a high influx to decentralized wallets means they are planning to hold for some time. You can use this information to guide you in making a wise investment decision.
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