Is Ethereum Becoming More Censored?  

Summary

Trading View (next 2-4 weeks): We like to be slightly bearish ethereum.

Investment View (next 1-3 years): We like to hold ethereum.

Macro Signals

• We expect 75bp hikes at the next two Fed meetings.
• The probability of a recession rises to 80%.
• Inflation came in hotter than expected for September.
• Fed minutes from the September FOMC meeting were hawkish.
• The macro backdrop is bearish for ethereum.

On-Chain/Flow Signals

• We have two bullish, three bearish, and one neutral signal this week.

Overall View

• With the macro backdrop bearish and our on-chain/flow metrics neutral, our overall signal is slightly bearish ethereum (Chart 1).

Ethereum Censorship

Ethereum censorship is becoming an increasing concern. In August, the US Treasury’s Office of Foreign Assets Control (OFAC) sanctioned the Tornado Cash mixer program. And since then, censorship of ethereum transactions has been on the rise via infrastructure known as MEV-Boost, which ethereum validators use to maximise revenues.

Decentralisation and permissionlessness are fundamental to cryptocurrencies. And the OFAC sanction has even resulted in crypto advocacy group, Coin Center, filing a lawsuit against the Treasury Department.

This week, we dive into what is driving the ethereum censorship concerns, and it starts with MEV (maximal extractable value).

What is MEV?

Validators (previously miners) are responsible for confirming new blocks to the wider network. Maximal extractable value (MEV) refers to the maximum value that can be extracted from block production in excess of staking/block rewards. It is captured by including, excluding, and reordering transactions in a block in an optimal way to maximise revenue.

For example, one way MEV works is by reordering or inserting transactions to maximise transaction fees. Common examples of MEV in practice include DEX arbitrage (taking advantage of mispricing of tokens across decentralised exchanges) and sandwich trading (a form of frontrunning that places trades around pending transactions).

This model has risks, though. Some believe it increases validator centralisation as smaller/solo validators will most likely be unable to benefit from MEV prospects (due to the resources needed to optimise for MEV) so may join staking pools. Also, traders and block producers could collude.

Ultimately, validators are responsible for proposing new blocks to the network. But that does not necessarily mean they all have the skills to build highly optimised and profitable blocks. This creates some separation between the concepts of block building and block proposing.

MEV-Boost

The separation of block building and proposing creates an environment for highly specialised actors to build MEV-optimised blocks and send them to relays from which validators can request the blocks and benefit from the MEV revenue.

Flashbots is a research and development organisation that aims to democratise MEV revenue. They are responsible for the most popular relay used by validators today: MEV-Boost. Flashbots describe MEV-Boost as ‘open-source middleware run by validators to access a competitive block building market’ and describe MEV as a ‘centralising force on Ethereum.’ Validators can run the MEV-boost software to get exposure to the most profitable blocks and maximise revenues.

Tornado Cash and Censorship Risks

Tornado Cash is an open-source cryptocurrency mixing service that runs on ethereum. It uses smart contracts to enhance privacy on the public blockchain by using cryptography to remove the link between a withdrawal and its deposit. In August, the US Treasury’s Office of Foreign Assets Control (OFAC) sanctioned Tornado Cash for money laundering allegations. Shortly after this, Flashbots announced that it will be OFAC compliant. This means that they would be censoring transactions.

There are multiple relays, but Flashbots is by far the most dominant relay, having processed over 80% of MEV-Boost blocks at press time. So, the largest relay is censoring transactions, but how many? A recent dashboard reveals that 59% of all blocks validated on ethereum post merge used some form of MEV-Boost software. And 52% of those blocks have used OFAC-compliant relays. This is obviously a loggerhead with the decentralised and permissionless framework on which ethereum was founded.

Currently, there are seven main MEV-Boost relays: Flashbots, BioXroute Max Profit, BioXroute Ethical, BioXroute Regulated, BlockNative, Manifold, and Eden. According to mevwatch.info, only three of these do not censor transactions according to OFAC requitements.

Censorship and regulation are important topics as cryptocurrencies come under increasing regulatory scrutiny. We believe regulation can be a good thing for investors as it would provide more safety and confidence. But we also recognise overregulation and censorship oppose the core values of decentralised and permissionless cryptocurrencies.

The Macro Backdrop: Inflation Persists

The macro backdrop for crypto remains largely bearish. Inflation came in hotter than expected (8.2% vs 8.1% expected) for September last week. This pushed US 10Y yields to 4% and meant our recession probability exceeded 80% again. We also got hawkish September FOMC minutes last week that appeared to show a Fed pivot is nowhere near. That said, risk assets have been performing broadly better since the CPI data last week, and this week’s corporate earnings will be the catalyst for any further moves.

On-Chain/Flow Metrics: Long-Term HODLers Dominate

We have two bullish signals this week:

• Liquidity demand: bias for outflows from exchanges.
• HODLer behaviour: long-term HODLers accumulate.

We have three bearish signals:

• Futures activity: futures open interest is low, and funding rates are still negative.
• DeFi: total value locked in DeFi for ethereum decreases, and DeFi overall TVL takes a hit.
• P&L: profitability of the coin supply is low, and realised losses dominate on chain.

The remaining signal is neutral:

• Institutional demand: ETF flows are muted.

On balance, on-chain/flow metrics are giving a neutral signal for ethereum. Here are the details of each metric (with explanations in the Appendix).

Institutional Demand: Neutral Ethereum

Our preferred metric to track institutional demand is flows into ethereum ETFs. Flows have been muted since the merge (Chart 2). This is neutral ethereum.

Demand for Liquidity and Exchange Activity: Bullish Ethereum

On exchange flows:

• Short term, a bias exists for outflows to exchanges. Net 1mn coins exited exchanges over the past 30 days (Chart 3). This is bullish ethereum.

• Longer term, the 30-day change in the exchange balance reveals fluctuations in the supply held on exchanges month on month. This metric remains in negative territory (Chart 4). This is bullish ethereum.

Futures Activity: Bearish Ethereum

Futures open interest is down 1% month on month – it is currently around $6.6bn (Chart 5). Around $5.6bn (85%) of this comes from perpetual futures contracts.

Perpetual funding rates reveal the directional bias of investors. They became sharply negative in the run-up to the merge. And while they have increased, they remain negative on average (Chart 6). This is bearish ethereum.

HODLers: Bullish Ethereum

The 30-day moving average of the coin days destroyed (CDD) metric has fallen of a cliff. It is down 44% over the past month (Chart 7), suggesting a significant slowdown in the movement of old coins.

Splitting HODLers into those who have held for under one year and those for one year or more shows the 1y+ vintage dominates 58% of the coin supply (Chart 8). There is still a sizable investor base with a strong conviction to hold.

We view these HODLer metrics as bullish for ethereum because a significant portion of the supply continues to hold continues despite ongoing macroeconomic and regulatory pressures in the space.

Investor Profit and Loss: Bearish Ethereum

On profitability of the coin supply:

• The percentage of circulating supply in profit (PSIP) is 46% (Chart 9). This means less than half of the circulating coin supply is at a profit.

• Net unrealised profit/loss (NUPL) is -0.11 (11% of market cap) (Chart 10). This means that the overall ethereum supply has moved back into an unrealised loss as realised cap exceeds market cap.

• Spent output profit ratio (SOPR, price sold/price paid) has been mostly below one (net losses) since September (Chart 11).

DeFi: Bearish Ethereum

DeFi has been taking a hit. The total value locked (TVL) in DeFi across all protocols is currently around $54bn compared with around $170bn at the start of the year. All chains in the top five by TVL are down in terms of their TVL on the week (Charts 12 and 13). Ethereum’s TVL is down 3% WoW. This is bearish ethereum.

Appendix

Institutional Demand

Perhaps the largest institutional vehicle for ethereum is the Grayscale ETHE Trust, with over $27bn in assets. It invests solely in ETH, and so many investors, notably institutional, who cannot hold ETH directly can get exposure through investing in Grayscale. Consequently, if the trust trades at a premium to ETH prices, it may imply ‘excess’ demand from institutions, but ‘excess’ supply if it trades at a discount. Alternatively, the discount may suggest investors have found other ways to get exposure to ETH, whether through ETFs or directly holding ETH. We therefore focus on how the discount has changed in recent months to gauge investor interest. Alternatively, investors may be using other vehicles to get exposure such as ETFs or holding ETH directly. We put more weight on ETF flows than the Grayscale premium.

Liquidity Demand

Another measure of cryptocurrency bullishness is whether investors are willing to hold it in illiquid form (e.g., a private wallet) or prefer a liquid form (e.g., on an exchange). The former would suggest investors are bullish, as they are comfortable with being unable to sell easily. Conversely, holding it in liquid form would suggest investors are bearish, as they prefer being able to sell easily.

Therefore, large flows onto crypto exchanges would suggest investors want to convert their holdings to a more liquid form, implying more bearishness.

Futures Activity

We track the growing market of ethereum futures. Open interest – the sum of long and short contracts – is a good measure of investor interest.

Perpetual funding rates reveal the directional bias of investors. Exchanges set funding rates to prevent a lasting divergence in the price of the futures contract and the underlying since perpetual contracts have no expiry date so never settle in the traditional sense. Consequently, we can interpret funding rates as the cost of holding ethereum via perpetual futures. Positive funding rates imply longs pay shorts and vice versa. We use it as a proxy for trader sentiment since a positive funding rate implies traders are paying a premium to keep open long positions.

HODLers

In our introductory bitcoin flow framework, we explained ‘HODLers’ and ‘HODLing.’ HODLing refers to buy-and-hold strategies in the context of bitcoin and other cryptocurrencies. Those who HODL for extended periods are die-hard adherents.

We can categorise HODLers by the length of time they have held ETH. We define long-term or staunch HODLers as those who bought ETH five or more years ago and have held it ever since, medium-term HODLers as those who bought 6-12 months ago, and short-term HODLers as those who bought 3-6 months ago.

The coin days destroyed (CDD) metric is defined as the number of coins in a transaction multiplied by the number of days since the coins were last spent. So, increasing CDD suggests older coins are being spent (more coin days are destroyed) and vice-versa.

Profit and Loss

• The percent supply in profit (PSIP). This tracks the share of circulating ETH supply in profit. That is the percentage of circulating ETH whose current price is higher than when it was last transacted (movement).

• Net unrealized profit and loss (NUPL). This is the ratio of unrealised profits over total market capitalisation. While PSIP just focuses on whether ETH coins are in profit or not, the NUPL focuses on the size of profits. So, we could have a situation where the PSIP is low – that is, a low share of supply is in profit – but the NUPL could be high if the size of those profits is large.

• Spent output profit ratio (SOPR). While PSIP and NUPL focus on unrealised profits or mark-to-market, this measure focuses on realised profits. SOPR is the realised value of a transaction divided by the value at initiation (or creation) – more simply, price sold divided by price paid. If SOPR is above one, investors in aggregate have realised profits, while below one means they have realised losses. In broad uptrends, SOPR spends a significant amount of time above one, whereas the opposite is true for broad downtrends.

When SOPR is rising, sellers are increasingly realising profits. The opposite is true when it is falling. A price rally with a flatter SOPR trend indicates investors are not yet realising their profits with the rally. The reluctance of investors to sell and realise a profit may be because they believe the price will increase further, which would be bullish. At the same time, more profit taking could precede a correction. Typically, buying as SOPR moves around one during bullish periods has proven to be a profitable strategy.

Mining Activity

Computing power is central to the crypto market. Miners use advanced computing hardware to solve complex problems that confirm ETH (and other coins) transactions on the public ledger or blockchain. The miners are rewarded with new coins for their efforts. A measure of the complexity of the problems and so the computing performance required to solve them is the hash rate. The higher this rate, the more computing performance is needed to maintain the blockchain. The rate can fluctuate depending on demand for crypto.

DeFi

We track the total value locked (TVL) in decentralized finance (DeFi) – the sum of all assets deposited in DeFi protocols, many of which use ethereum as the underlying protocol. The more DeFi products are created, the more ethereum gets locked into the DeFi system and removed from the broader market. This reduction in supply should lead to higher ethereum prices.

Dalvir Mandara is a Quantitative Researcher at Macro Hive. Dalvir has a BSc Mathematics and Computer Science and an MSc Mathematical Finance both from the University of Birmingham. His areas of interest are in the applications of machine learning, deep learning and alternative data for predictive modelling of financial markets.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)