Track market sentiment with liquidity pools

Author: Ding HAN, Alice Kohn, Glassnode; Source: glassnode

Summary

*In the past few weeks, due to the impact of certain events, the volatility of the digital asset market has increased, and at the same time, there have been significant signs of capital outflows.

• Derivatives markets are showing continued outflows of liquidity, especially on ETH futures, which means capital is moving from the highs of the risk curve to relatively safe positions.
• We have carefully studied the many similarities between the Uniswap liquidity pool and the options market, and interpreted liquidity providers' views on volatility and prices.

Digital asset market awakens

In recent weeks, the digital asset market has recovered from a period of historically mild volatility. This is mainly caused by the following two key events:

• The August 17 flash crash saw BTC and ETH fall by -11% and -13% respectively.
• On August 29, news of Grayscale’s victory against the U.S. Securities and Exchange Commission (SEC) pushed the price higher, but over the next three days, all previous gains were erased.

Currently, the spot prices of BTC and ETH are hovering around the August lows.

! [ETH] (https://img-cdn.gateio.im/resized-social/moments-40baef27dd-36ac256100-dd1a6f-6d2ef1) Real-time chart

"Total realized value" is a key metric used to track the total amount of capital flowing into the industry. This indicator combines:

• The realized market capitalization of the two major mainstream currencies BTC and ETH
• And the supply of the five major stablecoins USDT, USDC, BUSD, DAI and TUSD.

It can be seen that long before these two major events occurred, the market had already entered the stage of capital outflows in early August. Throughout August, approximately $55 billion in capital was withdrawn from the digital currency sector.

Mainly caused by the outflow of BTC, ETH and stable coins.

! [ETH] (https://img-cdn.gateio.im/resized-social/moments-40baef27dd-dca32249d5-dd1a6f-6d2ef1) Live Workbench Chart

In the Ethereum ecosystem, the index performance of the DeFi, GameFi and Staking sectors is significantly different. Each index is constructed based on the average supply-weighted price of "blue chip" tokens in the industry.

We can see that DeFi and GameFi tokens performed relatively poorly compared to major tokens (-17%) and (-20%), while liquidity staking tokens performed slightly better (-7.7%) . However, compared with the declines in March, April and June, the price decline this time is not significant.

! [ETH] (https://img-cdn.gateio.im/resized-social/moments-40baef27dd-8ccb848d3a-dd1a6f-6d2ef1) Real-time advanced charting

Derivatives market risk appetite declines

One of the key developments in the 2021-23 cycle is the maturation of derivatives markets, especially for BTC and ETH. The way derivatives markets price these assets can provide information about market sentiment and positioning.

Overall activity in the Ethereum futures and options market in 2023 was significantly below 2021 and 2022 levels. Average daily trading volume in these two markets has dropped to $14.3 billion per day, about half of the average volume over the past two years. This week, volumes were even lower at just $8.3 billion per day, indicating that liquidity continues to drain from the space.

! [ETH] (https://img-cdn.gateio.im/resized-social/moments-40baef27dd-57c59ea8ce-dd1a6f-6d2ef1) Live Workbench Diagram

Derivatives open interest reflects the same market trend. Following the market downturn caused by the FTX crash, open interest began to climb in early 2023. As far as options are concerned, open interest peaked during the banking crisis in March when USDC was briefly depegged from $1. On the other hand, open interest in Ethereum futures also hit highs around the time of the Shanghai upgrade, suggesting that this period may be the last wave of large-scale speculation in the asset.

Since then, the total notional value of active contracts in both markets has remained relatively stable. Similar to our observations of the BTC market, the Ethereum options market is currently similar in size ($5.3 billion) to the futures market ($4.2 billion) and is actually currently larger.

! [ETH] (https://img-cdn.gateio.im/resized-social/moments-40baef27dd-62fe71e132-dd1a6f-6d2ef1) Live Advanced Charts

Since the beginning of the year, the Ethereum options market has seen a marked uptick, with trading volume up 256% to $326 million per day. Meanwhile, futures trading volumes have continued to decline this year, from $20 billion/day in early January to $8 billion/day now. The only thing worth noting is that before and after the Shanghai upgrade, the futures trading volume briefly rose to around $30 billion per day.

Given that neither market saw significant changes in trading volumes in August, this suggests traders are continuing to shift liquidity higher up the risk curve.

! [ETH] (https://img-cdn.gateio.im/resized-social/moments-40baef27dd-c53c94c203-dd1a6f-6d2ef1) Live Workbench Chart

Looking at the "pull/call" ratio, we can see a high degree of response to major news events. For example, after BlackRock filed for a Bitcoin ETF, market sentiment became more bullish, pushing the Pull/Call ratio down from 0.72 to 0.40.

However, things changed with the sell-off on August 17, with the Pull/Call ratio rising to 0.50 and call volume falling significantly from $320 million/day to $140 million/day.

! [ETH] (https://img-cdn.gateio.im/resized-social/moments-40baef27dd-c2fdb71d83-dd1a6f-6d2ef1) Live Workbench Chart

Is the liquidity pool an options market?

To strengthen our above analysis, we chose automated market makers like Uniswap ETH/USDC Pool for research. Since the introduction of centralized liquidity on Uniswap V3, there has been a widespread argument: Uniswap’s liquidity position can be viewed as a pricing strategy for put and call options. While we don't entirely agree that they are exactly equivalent to options, there are undoubtedly many similarities between the two that deserve further exploration.

We will focus on analyzing the USDC/ETH 0.05% pool, which is the most active Uniswap pool and therefore provides the strongest market signals. The pool has a 7-day trading volume of $1.51 billion and a total value locked (TVL) of $260 million.

Uniswap V3 has the unique feature of liquidity concentration. Liquidity providers (LPs) can choose a price range and provide liquidity centrally. Fees are earned only when the market trades within that range (similar to the strike price), and the narrower the range, the higher the relative fee income. This method of centralized liquidity not only provides traders with a better trading experience, but also enhances the efficiency of capital use by liquidity providers.

Therefore, it can be said that the positioning of LP capital must take into account the expected volatility (the price difference between the upper and lower limits) and the expected price range (the upper and lower strike levels). Our thesis is that we might be able to draw similar insights from options market data, assuming liquidity providers are actively managing their positions.

! [ETH] (https://img-cdn.gateio.im/resized-social/moments-40baef27dd-2f074bd30e-dd1a6f-6d2ef1) Source: Uniswap White Paper

We first observe the overall activity of the USDC/ETH 0.05% pool. For various reasons, we will avoid using the TVL metric to measure the activity of a pool or corresponding token pair. Instead, we will represent liveness with two metrics:

1 Daily coinage represents the number of liquidity positions opened by liquidity providers,

2 Daily burn volume represents the number of liquidity positions closed by liquidity providers.

Judging from these indicators, after the banking crisis in March and the Shanghai Stock Connect upgrade in April, market activity shrank and remained relatively low until early June. We then saw a surge in new mints and burns around the time of the BlackRock ETF announcement, and then another surge during the August 17 sell-off.

The chart below also shows the net change in liquidity provider open interest, which is a measure of the balance between opening and closing positions. We note that this indicator is less affected by market trends but more by discrete events, suggesting that short-term volatility is a key factor.

! [ETH] (https://img-cdn.gateio.im/resized-social/moments-40baef27dd-f34fbe6570-dd1a6f-6d2ef1) When studying the liquidity distribution of different price ranges in the Uniswap pool, we found that most of the liquidity is set above current prices.

The most concentrated liquidity (approximately 30.4% of capital) is within approximately 11% of the price range, with expected price fluctuations ranging from -2.7% to +8.6%. The price downside buffer for Level 2 liquidity is -8.5% and the upside buffer is +23.7%. It can be said that Uniswap’s liquidity providers have expressed optimistic expectations for ETH and expectations for the overall upward trend of the market.

! [ETH] (https://img-cdn.gateio.im/resized-social/moments-40baef27dd-59b7869859-dd1a6f-6d2ef1) If we compare this to option strike prices for end-September expiry, we see a similar positive prospect. 70% of the calls have strike prices between $1,700 and $2,300, while 75% of the puts have strike prices between $1,300 and $1,900. These price levels are generally consistent with the liquidity distribution of the Uniswap liquidity pool.

! [ETH] (https://img-cdn.gateio.im/resized-social/moments-40baef27dd-a0c8599c3a-dd1a6f-6d2ef1) Real-time professional chart

Going back to the USDC/ETH Uniswap pool, we can analyze how liquidity concentration has adjusted over time. The heatmap below shows the density of fluidity, with colors increasing from cool to warm.

With the expansion of automated LP strategies and execution, liquidity providers have successfully provided liquidity close to spot prices during periods of greater volatility. On June 1st, significant liquidity was just above the price at that time (shown by the deeper yellow area). Arguably, this indicates that market makers expect higher fee income in this area. This liquidity continued until the August flash crash, when liquidity concentration was adjusted increasingly below $1,800. This chart provides us with a unique perspective on how quickly liquidity providers respond to market events and price fluctuations.

It is also interesting to note that the high concentration of liquidity represented by the red zone tends to coincide with strong price movements as well as trend reversals. By studying the Uniswap liquidity pool, we can better understand the market sentiment and positions, which provides us with valuable market insights.

ETH summary and conclusion

Optimism about Grayscale’s victory over the SEC was short-lived, with Ethereum’s value falling back to its August lows within days. Capital outflows from the spot market continue, and liquidity in the derivatives market continues to decline. Overall, investors appear hesitant to return to the market, preferring to move funds higher up the risk curve.

We conducted research on Uniswap liquidity pools to try to determine whether pricing information similar to that of the options market is available. Our analysis shows that liquid capital is quite responsive to market events, and it is possible to find cues in the volatility and price expectations of liquidity providers.