Bitcoin off-chain transactions bring billions of dollars to the market. What new opportunities are there for blockchain expansion?

Overview

• Hundreds of billions of dollars have been transferred on blockchains each week since the beginning of 2021, with Bitcoin, Ethereum, USDC, and Tether (on Ethereum) averaging $236 billion per week. These massive transactions have generated billions of dollars in transaction fees: $4.1 billion in Ethereum transaction fees and $900 million in Bitcoin since the beginning of 2021. Blockchains such as Solana are focused on increasing their competitiveness and earning more transaction fees by scaling.

• To quantify the opportunities that scaling can bring, I looked at asset transfers on blockchains. In Bitcoin, 82% (upper limit) of the USD value of Bitcoin transferred so far in 2021 has been traded with an exchange. The other counterparty is almost always another exchange, or a large trader or investor.

• In fact, the vast majority of Bitcoin transactions occur between only a few whales, which explains why custodians working with exchanges perform so well. These custodians provide scalability by eliminating the need to transfer assets on-chain. On the other hand, Ethereum is increasingly dominated by DeFi, which inevitably involves on-chain transfers, so Ethereum's competitors will strive to improve the scalability of the blockchain.

Last week, the price of Bitcoin fell slightly, from $47,800 at the close of August 13 to $47,200 on August 20, but it recovered over the weekend and today (August 23) is fluctuating around $50,000. Ethereum is in a similar situation to Bitcoin, with its price also falling slightly last week, but it has now returned to around $33,000.

The crypto asset that has caught people’s attention last week is Solana, whose price rose from $45 (August 14) to a peak of $80 (August 18) before gradually returning to its current level of around $73 (August 23). Solana is a layer 1 blockchain focused on improving scalability and thus a potential competitor to Ethereum.

Hundreds of billions of dollars worth of assets are transferred on blockchains every week. As shown in the figure below, Bitcoin, Ethereum, USDC, and Tether (on Ethereum) have an average weekly transaction volume of $236 billion. From the beginning of the year to now, Ethereum has generated $4.1 billion in transaction fees, while Bitcoin has generated $900 million in transaction fees. In other words, in addition to block rewards, there are also many rewards for processing transactions on the blockchain. Therefore, for blockchains that do better in scalability, these expensive transaction fees provide them with an opportunity to process more transactions at a lower cost, thereby attracting users to use them.

But why do assets need to be transferred on-chain? This is a difficult question to answer. Blockchain analysts usually focus on a few well-known entities [1] and only pay attention to whether funds flow into or out of a certain entity, without paying attention to the flow of funds between entities. This means that although the blockchain keeps a complete record of all asset transfers, this unique advantage of the blockchain is not being fully utilized. Analysts can only partially understand what is happening on the blockchain, not all of it.

This is typical because identifying all the different types of entities on a blockchain is complex and resource intensive because assets often flow between entities through intermediate addresses on the chain. Therefore, tracking the flow of assets between entities requires technology to track which intermediate addresses the assets "hop" through.

Fortunately, Chainalysis can now identify thousands of companies on the blockchain and has built technology to quantify the flow of assets between companies through intermediate addresses. Chainalysis' research covers more than a hundred crypto assets, but this week's report will focus on Bitcoin, which is the second most traded asset in U.S. dollar transactions, second only to Ethereum, and can help us understand the flow of crypto assets.

Most of the money flow of Bitcoin occurs between exchanges. From the data of the beginning of the year to date, this part of the transaction accounts for 38% of the total value of Bitcoin. The money flow between self-hosted entities (entities that use their own resources to host websites and manage internal servers) also accounts for 38% of the total, while the money flow between exchanges and other entities accounts for 18% of the total, and the money flow between other types of entities accounts for only 7%. We can see the money flow of Bitcoin in the figure below.

There is a nuance to this that may increase the share of Bitcoin flowing into and out of exchanges. That nuance is that much of the Bitcoin transferred from self-custody entities may not go to a new entity, but rather “hop” through an intermediate address controlled by the sending entity. This can be clearly seen in the data: as shown in the chart below, 80% of the Bitcoin transferred out of self-custody entities so far in 2021 was transferred by entities that held the asset for less than two weeks, the average time these entities held the Bitcoin was just 5 days, and, as I said in my August 6th market report, most of these Bitcoin transfers were for less than 0.1 BTC.

This means that up to 80% of asset flows initiated by self-custodial entities may be internal transfers between addresses controlled by one entity, rather than asset exchanges between different entities. Internal fund flows are important for asset management, especially on UTXO blockchains (UTXO, a special account accounting model that is one of the core concepts of Bitcoin), but I personally believe that the main purpose of transfers is to facilitate economic exchanges between different entities. Therefore, if 80% of asset transfers between self-custodial entities, which account for 38% of total Bitcoin transactions, are internal to this entity, then the share of asset transfers between self-custodial entities will shrink to 8%, while the share between exchanges will increase from 38% to 56%, and the share between exchanges and other entities will increase from 18% to 27%. Therefore, in terms of Bitcoin, 82% (upper limit) of the USD value of Bitcoin transferred so far in 2021 has been traded with exchanges.

This suggests that the movement of Bitcoins on the blockchain is primarily about moving them in and out of exchanges. Right now, the primary use of Bitcoin is to hold it, not to move it; however, when Bitcoin is moved, exchanges are the primary source and destination. Therefore, if you want to improve Bitcoin's scalability, you should focus on moving Bitcoins between exchanges (and potentially reducing the need to move assets between internal addresses).

But with on-chain data, we can get a more specific look at who will benefit from Bitcoin's scalability. As mentioned above, most Bitcoin flows between exchanges, but 32% of inflows come from other sources, as shown in the figure below. Since the beginning of 2021, 15% of inflows to exchanges have come from large traders, 5% from large investors (large refers to investors holding at least 1,000 Bitcoins), while assets from other institutions account for 7% of total inflows to exchanges, and assets from self-custodial entities account for less than large traders and investors, accounting for only 5%. Therefore, Bitcoin's scalability is actually about improving the transfer of assets between hundreds of exchanges, hundreds of large traders, and thousands of large investors.

The fact that the vast majority of Bitcoin transfers involve only a few large players explains why crypto custodians have outperformed, with Fireblocks, for example, tripling its valuation to $2.2 billion in five months. Crypto custodians not only hold private keys for large investors, they also work with exchanges so that these assets can be traded or used as margin without having to move between different blockchains.

By centralizing assets in custodians, Bitcoin has achieved scalability. But this is not what I expected in the 2017 Scaling Wars. While the Liquid Network is a sign in this direction, I have also talked about the possible "heat death" of Bitcoin before, that is, Bitcoin becomes so valuable that everyone wants to hold it forever, which means that liquidity and on-chain transactions may drop to 0.

Ethereum stands in stark contrast to Bitcoin. The increase in decentralized businesses means that on-chain activity is increasing. Decentralized exchanges and financial services can thrive because they are decentralized, which allows them to be open to rapid innovation, but also makes fund transfers only possible on-chain. This is why transfer fees on Ethereum are 4.5 times that of Bitcoin in 2021, and why blockchains like Solana are focused on DeFi expansion. Bitcoin, on the other hand, does not need to be open to rapid innovation because it is technically limited to operations other than fund transfers. If you can't write smart contracts on Bitcoin, then you might as well put your Bitcoin in a custodian company where more complex applications can be written in off-chain code.

I don’t write specific price analysis articles, instead, I hope my articles can make it clear how on-chain data can quantify various opportunities happening in the industry. For example, Solana is eyeing billions of dollars in Ethereum transaction fees, and crypto custody companies have built businesses by solving the problem of moving Bitcoin on the chain. On-chain data can not only allow us to understand price movements, but also identify industry opportunities.