On-chain transaction volume is the heartbeat of blockchain networks. For digital asset investors, monitoring these flows within the network and comparing them across protocols is a way to determine the protocol’s adoption rate and usefulness, and determine whether a project is moving forward or is an outdated relic of the previous market cycle.
This perspective gives us valuable insights into user activity, network utility, and the overall health of the crypto ecosystem. An increase in transaction volume often means increased network usage, adoption and trading activity. It could indicate growing interest, a new protocol or even speculative enthusiasm. Conversely, a decline in on-chain transaction volumes may indicate reduced network development, protocol stagnation, or loss of market share to other competitors.
Several factors determine blockchain trading volume, and understanding these nuances helps us navigate the ever-evolving crypto market cycle. During bullish phases, when the crypto market resembles a bullish festival of excesses, trading volumes tend to increase. Positive news, such as regulatory clarity, institutional adoption or significant protocol upgrades, can lead to increased trading activity.
In addition, market sentiment plays a crucial role. The bullish sentiment often drives traders and investors to flock to decentralized exchanges, causing a surge in on-chain transactions. There, they are typically more focused on trading newer innovative products such as NFTs and smaller token launches, which have a greater impact on on-chain activity than large tokens traded within centralized exchanges. This contributes to higher trading volumes during bullish cycles.
Conversely, trading volumes begin to dwindle during bearish periods, with bursts of activity around deleveraging periods. Uncertainty, negative news, regulatory crackdowns or market corrections often lead to a decline in trading. Investors could take a wait-and-see approach, which could lead to lower transaction volumes, and they could move their assets to cold storage or stablecoins, reducing overall trading activity on the exchanges.
To better address the usefulness of on-chain transaction volume data, we use data from SonarVerse, which provides OnChain Trading Dollar Volume by Protocol, and compare volume between Bitcoin, Ethereum, and Polygon protocols.
To normalize the volume for these protocols, we divide the transaction volume by the market capitalization of the protocol. (see figure 1 below)
Figure 1: On-Chain Trading Volume/Market Cap, by Protocol, 30d Smoothed, Source: SonarVerse, CoinDesk Indices Research
Here we can see bitcoin’s relatively low and stable transaction volume, with Ethereum and Polygon having peaking and relatively compensating activity, which makes sense considering that Polygon is an EVM scaling solution for Ethereum-based protocols.
To further highlight the investment benefits of this data, we perform a very simple backtest where we rotate between Ethereum and Polygon protocols based on recent normalized on-chain volume activity with the simple rule that when normalized Polygon trading activity is greater than that of Ethereum, we rotate in Polygon, otherwise we hold the Ether token (see Figure 2 below for a hypothetical backtest strategy).
The rotation strategy improves absolute and risk-adjusted returns over a crypto market cycle compared to separate allocations to Ether and Polygon tokens. This outperformance could be due to the information in the on-chain trading volume metric, which shifts the hypothetical strategy towards protocols with greater recent activity, and therefore greater demand for blockchain protocols.
Figure 2: Ether/polygon rotation strategy, long-only. Source: SonarVerse, CoinDesk Indices Research
By understanding the dynamics of on-chain activity, we can better assess market sentiment and make more informed trading decisions by assessing the underlying protocol status. During bullish phases, high trading volumes can indicate potential profit opportunities or increased volatility. In bearish cycles, low volumes can indicate a potential market bottom or opportunities for accumulation.
Keeping an eye on on-chain transaction volumes and other blockchain metrics like TVL is like listening to the heartbeat of the crypto market, helping investors navigate the twists and turns caused by developments in the sector.