Monday, 19 February 2018
Bitcoin

Bitcoin’s Record-Low Volumes Provide Opportunity


It has been a pretty quiet week for Bitcoin (OTCQX:GBTC, COIN). On-chain confirmed transactions are some of the lowest in years, dating as far back as March 2016. However, Bitcoin trading volume remains strong. This may indicate that fewer users are moving Bitcoins on/off exchange, perhaps indicating declining numbers of new users or users cashing out of Bitcoin.

Bitcoin has offered amazing risk-adjusted returns over the past few years, as observed by JPMorgan (JPM). Ethereum’s past-year Sharpe ratio is an amazing (and unsustainable) 41.4, while Bitcoin’s is “only” 6.6. Despite those returns, JPMorgan warns investors that cryptocurrencies shouldn’t be used as a primary hedge.

Generally, I encourage cryptocurrency investors to only invest what they can afford to lose. Cryptocurrencies have attracted a lot of new investors, but those investors should be wary of their volatility and the dangers of an undiversified portfolio. Personally, I plan on using the low Bitcoin fees to trade some of my Bitcoin Cash (received from the August 2017 fork) for Bitcoin, and then move the coins back into paper wallets.

I also advise all investors to ignore every prediction about where Bitcoin’s price might be in a week, a month, or a year – no one knows. Focus on the technology and its adoption. Price will ultimately follow technology and adoption.

Bitcoin’s Lowest Volume In Years

Over the past week, Bitcoin has seen remarkably low volume. Depending on how volume is measured, Bitcoin volume is at its lowest level in months or years.

Seven-day average Bitcoin transactions/day. From Blockchain.

Number of Confirmed Transactions/Day: Bitcoin transactions per day have fallen dramatically since late December. On February 10, there were 147,000 transactions on the Bitcoin blockchain. This was the second-lowest number of transactions since March 2016. Meanwhile, the seven-day average number of transactions/day fell to 196,000 on February 10. This is the lowest seven-day average since March 2016.

A Bitcoin transaction includes sending BTC from one or more wallets to one or more wallets on the blockchain. Each transaction can include multiple inputs (sending wallets) and multiple outputs (receiving wallets). Each transaction is confirmed when it is included in a block – this figure does not include unconfirmed transactions which are still in the memory pool.

Users and exchanges may “batch” their transactions by sending to multiple different users in the same transaction. For example, Blockchain provides a listing of the largest recent transactions, which can often have 20 or more output addresses per transaction. This means that transactions/day may not completely reflect Bitcoin usage if the number of outputs/transactions is changing over time. Batching is also used for transactions over the Lightning Network.

Daily transaction volume in Bitcoins. From Blockchain.

Daily Volume in Bitcoins: On February 10, Blockchain estimates that 86,000 BTC changed hands in transactions. That is the lowest transaction volume since November 2014 – over three years ago.

Of course, Bitcoin is also up well over 700% in the past year – Bitcoin was worth only $999 on February 12, 2017. Because of that, this lower volume, in BTC, is still a much higher volume than previous dates.

Outputs per Bitcoin block. From Outputs.today.

Daily Outputs: Perhaps the best metric of Bitcoin usage is a count of the daily number of outputs. Because of batching, each individual Bitcoin transaction can be serving many different users. Thus, counting the total number of outputs in all daily transactions may provide a more accurate measure of Bitcoin usage, since it might better measure the total number of users using Bitcoin for transactions.

So far in February, two different days have averaged fewer than 3,000 outputs/block. Only three other days this year averaged so few transactions per block, all in July. Given that mining time is relatively steady at ~ 8.5-11.5 minutes/block, this may indicate that Bitcoin is seeing less use in February than it has seen at least since July, prior to Bitcoin’s massive run to $20,000.

Bitcoin trading volume on popular exchanges, per minute (weekly average). From Bitcoinity.

Trading Volume: But note that Bitcoin trading volumes have not declined significantly. While volumes are down a bit from the height of Bitcoin’s December run-up, 24-hour volume remains at levels higher than those seen prior to American Thanksgiving.

I suspect that the lower blockchain transaction volume reflects the increased use of batching, and perhaps lower numbers of new users buying into Bitcoin.

Based on my own Bitcoin usage (I purchased Bitcoin over the course of a few weeks in late 2013, and added additional Bitcoin in March 2017, before selling in December 2017), I expect that many long-term Bitcoin holders move their BTC off exchanges to paper or hardware wallets. Meanwhile, traders who are more interested in liquidity are more likely to keep their money on exchanges – which will not add to the on-chain transactions counts shown above. Thus, a drop in the number of transactions and outputs without a drop in trading may reflect that similar numbers of traders are trading Bitcoin, but that fewer new buyers are purchasing Bitcoins and moving them off-exchange and/or that fewer existing holders are moving coins from their wallets to exchanges to sell those coins. Other explanations are also possible.

Low Volume = Very Reasonable Transaction Fees

Bitcoin median transaction fee. From Bitinfocharts.

Bitcoin’s transaction fees are directly related to Bitcoin’s transaction volume. Each block has a limited amount of block space to store transactions, and each block is mined at an approximately constant rate. So as transaction volume falls, transaction prices have also been falling.

Bitinfocharts lists the 24-hour median Bitcoin transaction as costing only $2.06 USD. That is lower than the median fee since October 2016, and still over-represents the actual cost to send Bitcoins. Here is a histogram of Bitcoin transaction prices over the past 24 hours:

Bitcoin 24-hour (as of Feb 12, 2018 at 11:00 am PT) fee histogram. From Bitinfocharts.

The chart above shows two spikes in Bitcoin fees – one at $2.20, and one at $0.12. Paying fees of even $2 is unnecessary in today’s Bitcoin environment and is likely the result of auto-suggested fees from popular exchanges and wallets. Those suggested fees are likely calibrated too high, leading to users paying significantly more fees than are required to send transactions.

Personally, I use Bitcoin Fees to estimate the fee to use for my Bitcoin transactions. Right now, transactions with fees as low as 11-20 satoshis/byte are expected to be transmitted in the next block. Further, over 8,000 transactions with fees of 1-10 satoshis/byte have been confirmed in the past 24 hours. If we assume that an ordinary transaction is 150 bytes, a fee of 11 satoshis/byte works out to 1,650 satoshis, or about $0.14 USD.

I have often complained (now behind a paywall) of high Bitcoin fees. But we are no longer in that environment – Bitcoin fees are now extremely reasonable.

These low fees should allow more users to, for example, move their funds off exchanges and into paper or hardware wallets. Keeping funds in a paper or hardware wallet is often more secure than keeping them on exchanges, given the history of Bitcoin exchange hacks in the past. Personally, I would recommend using a SegWit-enabled wallet, like the Trezor (hardware) or Electrum (mobile).

JPMorgan Talks Bitcoin

Rolling Sharpe ratios for IVV, BTC, and ETH. Based on data from Yahoo Finance and Coinmarketcap.

According to a Seeking Alpha news story, JPMorgan has observed that cryptocurrencies offered amazing risk-adjusted returns over the past few years. This is hardly news to anyone who has been following the market.

Since January 1, 2016, a $100 investment into the S&P 500 via IVV would be worth $264. Not bad, but the same money put into Bitcoin would be worth $880, and the same money put into Ethereum would be worth $8,737, as of the end of February 9. It would take a lot of volatility to offset those gains. And cryptocurrencies – while extremely volatile, aren’t volatile enough to offset those gains.

Asset One-Year Total Return
(As of Feb. 9)
Annualized
Volatility
Sharpe RatioCorrelation to IVV
S&P 500 (IVV)15.3%11.5%1.25100%
Bitcoin784%118%6.618.1%
Ethereum7,736%187%41.418.3%

Based on data from Yahoo Finance, Coinmarketcap, and the St Louis Fed.

All data above is based on daily volatility which has been annualized. Sharpe ratios are calculated based on the returns on a 3-month treasury, which were about 1%.

We examine the potential role of CCs in terms of offering diversification in a global portfolio, given both their high returns over the past several years and their low correlation with the major asset classes, offsetting some of the cost of high volatility. If past returns, volatilities and correlations persist, CCs could potentially have a role in diversifying one’s global bond and equity portfolio. But in our view, that is a big if given the astronomic returns and volatilities of the past few years. If CCs survive the next few years and remain part of the global market, then they will likely have exited their current speculative phase and would then have more normal returns, volatilities (both much lower) and correlations (more like that of other zero-return assets such as gold and JPY). Based on its historical performance, CCs can be 10 times more volatile than core assets like stocks, or than portfolio hedges, like commodities. Liquidity is also well below most other potential hedges. Extraordinary returns can be generated in the price discovery phase, only to be followed by several years of mean-reversion toward the eventual, long-term average level. In the current market conditions, we do not believe that an allocation to Cryptocurrencies as insurance should be a portfolio’s main or only hedge. Note that even though CCs have improved risk-adjusted returns over the past several years, they have not prevented portfolio drawdown during periods of acute market stress, like the equity flash crashes of August 2015 and February 2018.”
– JPMorgan via ZeroHedge (emphasis from ZeroHedge)

Overall, JPMorgan’s review is hardly a glowing recommendation. The bank properly notes that cryptocurrencies have shown great returns, real and risk-adjusted, over the past several years. However, it also notes their extreme volatility and predicts that future returns and volatility are likely to be much lower than past returns.

Update on $100,000 Cryptocurrency Portfolio

This was worth $100,000 on January 10, 2018. Live Coin Watch.

My hypothetical, cap-weighted, top-ten-coin portfolio from January 10, 2018, (paywall) continues to suffer. What was once $100,000 is now worth $58,000. This is still a substantial improvement from the lows of February 6 when the portfolio touched as low as $40,050. Individually, every single one of the coins in the portfolio has lost value. The worst performer has been NEM, which dropped from $1.49 to $0.55 (-63%), while the best performer has been Stellar, which dropped from $0.56 to $0.39 (-31%). Performance over the past month has been abysmal across the board.

Personally, I continue to hold Ethereum (purchased a couple years ago) and Bitcoin Cash (forked from my existing Bitcoin in August 2017). I plan to use the low Bitcoin fees to exchange some of my Bitcoin Cash for Bitcoin over the next week – primarily to diversify my coin holdings. I would suggest that others who have been avoiding transmitting Bitcoin on-chain also take advantage of Bitcoin’s lowest fees in months.

** Author’s note: If you enjoyed this article, please hit “Follow” next to my name at the top of the page. This helps me build my readership and increases my visibility on Seeking Alpha. Please also leave questions, comments, feedback, and suggestions below. Thanks for reading!

Disclosure: I am/we are long ETHEREUM, BITCOIN CASH.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may exchange Bitcoin Cash (BCH) for Bitcoin (BTC) in the next week.





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