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A Bitcoin supply shock appears to be underway. But what exactly is it? And how do we know when a supply shock is coming?
Here’s everything you need to know about Bitcoin supply shocks and how to predict them using on-chain data.
What is a Supply Shock in Bitcoin?
A Bitcoin supply shock occurs when a rapid increase in demand outpaces the issuance of new supply and the available supply on exchanges.
During a supply squeeze, buyers are forced to bid up the price if they want to acquire the bitcoin they’re pursuing, which increases the price and attracts even more market participants.
FOMO further feeds this cycle, and many new retail buyers are often the catalyst for bitcoin rallies.
Put simply: a Bitcoin supply shock happens when there are many more buyers than sellers, resulting in the buyers competing for a limited supply.
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Understanding Bitcoin Supply Shocks
Bitcoin has far different supply and demand dynamics than the average asset. Unlike fiat, Bitcoin’s supply is predictable and can be tracked on the Bitcoin Blockchain.
This transparent supply schedule, in conjunction with real-time supply data, allows investors to analyze Bitcoin’s market structure in detail.
For example, Bitcoin’s circulating supply can be separated into two categories: liquid supply and illiquid supply. These essentially describe the likelihood that a given coin will be spent.
A large percentage of the circulating supply is considered illiquid, meaning there is a very low probability they will be spent.
Therefore, a more accurate measure of ‘circulating supply’ is liquid supply — coins with a higher probability of being spent.
When buyers come into the market, they’re buying from the liquid supply, representing a decreasing total supply percentage.
The differentiator in Bitcoin is that all of this data can be tracked and analyzed.
On-chain metrics reveal when the available supply is drying up and indicate when a supply shock might be imminent.
Interpreting Bitcoin Supply Shock
The Illiquid Supply Shock (ISS) Ratio captures the relationship between illiquid and liquid supply and attempts to model the probability of a supply shock forming.
This on-chain metric was created by Will Climente and Willy Woo in 2021.
The on-chain platform Glasssnode attaches probabilities to entities to approximate their intent. Here’s how it defines these two inputs:
- Liquid Supply: total coins held by entities that tend to sell 75% of BTC they buy
- Illiquid Supply: total coins held by entities that tend to hold at least 75% of BTC they buy
The ISS Ratio increases when coins are primarily flowing out of liquid circulation, suggesting a higher probability of a supply shock.
The ISS Ratio decreases as illiquid coins are spent back into liquid circulation, suggesting a lower probability of a supply shock.
Illiquid supply increases during an accumulation phase, which tends to be bear markets where “smart money” is buying the fear and new market participants are selling.
These buyers plan to hold onto at least 75% of the coins they’re buying.
Bitcoin’s available supply shrinks as these coins exit exchanges and is sent into deep cold storage.
Thus, there are far fewer coins for retail to buy the next time they enter the market.
This behavior has happened cycle after cycle and can be supported by the on-chain metrics.
Bitcoin Supply Shock Charts
Below is a recent chart of bitcoin’s price (black) compared to the ISS Ratio (purple):
When the ISS Ratio increases, people accumulate coins with little intention of selling, resulting in fewer coins on exchanges for people to buy, and the price gets bid up.
However, everyone has a price. Smart money eventually takes some profits as they sell their coins into strength. During a significant price increase, buyers tend to be new market entrants and short-term holders.
This transfer of coins from illiquid entities to liquid entities causes the ISS Ratio to decrease, but now there’s enough buying momentum to carry the price higher.
The ISS Ratio began a downtrend after clipping $60K for the second time last spring. A sustained downtrend in the ISS Ratio means coins are flowing into the hands of new market participants.
As you can see, the ratio decreases several days before price, demonstrating the ISS Ratio’s nature as a ‘leading indicator.’
This metric is not used to call tops and bottoms. It’s better used to determine if we’re heading for a bull or a bear market based on the behavior of long-term holders.
Bonus: Illiquid Supply Floor
A Bitcoin price floor can also be created by comparing the illiquid supply data (red) with Plan B’s Bitcoin Stock to Flow Model (black):
Stock to flow (black) attempts to forecast the price of bitcoin-based on its supply dynamics and overall scarcity.
Overlaying real-time supply data adds some context to Bitcoin’s scarcity at any given time.
Illiquid Supply Floor (ISF) was created by Will Climente and Matt Faltyn and extends Plan B’s famous S2F model.
The ISF model currently pegs bitcoin’s price floor at $39K.
FAQs: Bitcoin Supply Shock
Is Bitcoin in a supply shock?
The on-chain metrics suggest that Bitcoin is heading towards a supply shock. Bitcoin’s Illiquid Supply Shock Ratio, an on-chain metric that compares the illiquid supply to the liquid supply, has just broken its previous high. Over 14.5 million of the 19 million circulating coins are currently held by illiquid entities. Considering ~4 million coins are permanently lost, about 97% of coins are in illiquid hands. What happens next?
What happens after a Bitcoin supply shock?
A rapid increase in bitcoin price is often due to a supply shock. These “shocks” can play out over several trading days, weeks, or months and largely depend on the underlying market structure.
What affects the supply of Bitcoin?
Absolutely nothing. The supply rate of Bitcoin cannot be changed and is predetermined by the protocol. Unlike fiat currencies, where new supply can be issued at random, Bitcoin has a programmatic supply schedule that it will follow until the last coin is mined in 2140.
Bottom Line: Bitcoin Supply Shocks
Bitcoin’s parabolic moves seem random to the casual observer, but the on-chain supply metrics can pick up on parabolic momentum well in advance.
Bitcoin’s next vertical move will be the result of a supply shock.
This article is for informational purposes only. It is not intended to be investment advice.