Why Bitcoin exchanges aren't as straightforward as they seem

Bitcoin is the most popular virtual currency yet developed. Proponents assert that bitcoin can remove frictions involved in payment and settlement systems by eliminating the need for the financial intermediaries that exist in traditional currencies. In this blog post, we show that while bitcoin transfers themselves are relatively frictionless for the user, there are significant frictions when bitcoins trade in exchange markets resulting in meaningful and persistent price differences across bitcoin exchanges. These exchange-related frictions reduce the incentive of market participants to use bitcoin as a payments alternative.

The Case for Bitcoin

A virtual currency may be defined as “a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community.” Bitcoin is a virtual currency and online payment system that was launched in 2009. It operates without any central authority according to a mutually agreed upon set of code comprising the bitcoin protocol. Bitcoin contrasts with traditional fiat currencies, such as the dollar and euro, which are issued and regulated by a central authority (such as a governmental body) and constitute legal claims on their issuers. For example, bank deposits are claims on the assets of banks and Federal Reserve notes (such as dollar bills) are technically claims on the assets of the Federal Reserve System.

The entire history of bitcoin transactions is recorded on a public ledger known as the blockchain. Proponents such as the Bitcoin Project assert that the bitcoin protocol can reduce the fees, time, and risk associated with transferring value in terms of traditional currencies. For example, payments submitted over the U.S. Automated Clearing House (ACH) network still take one-to-two business days to settle compared to roughly ten minutes for bitcoin payments. Since its inception, bitcoin has become accepted for payment by a wide variety of businesses and nonprofit institutions. Bitcoin-based start-ups and projects have proliferated. For instance, in March 2014, Bank of America filed a patent for a system of executing wire transfers using cryptocurrency (such as bitcoin) exchanges to mediate between two sovereign currencies.

But Just How Frictionless Is Bitcoin Really?

Bitcoin-to-bitcoin transactions between digital wallets can be performed at a negligible cost relative to transaction amounts. However, unlike traditional currencies, bitcoin does not currently serve as a widely accepted unit of account in and of itself. Therefore, most users seeking to make payments in bitcoin generally need to purchase it on third-party exchanges using traditional currency. After receiving bitcoin in a transaction, the user has the option of holding it with the expectation of using it in a subsequent transaction. However, bitcoin’s large exchange rate volatility and negligible correlation with traditional currencies undermines its usefulness as a unit of account or a store of value. Therefore, the bitcoin payee may be better off exchanging the bitcoin for traditional currency which is more useful as a general unit of account. This phenomenon can be observed in practice since many large retailers, such as Dell, Microsoft, and Expedia, that accept payment in bitcoin never actually receive any bitcoin. Rather, they utilize third parties who, for a fee, receive bitcoin from the customer and forward dollars to the retailer. The round-trip transaction from traditional currency to bitcoin and back (see the diagram below), may entail potentially significant transaction fees and counterparty risk. In turn, these exchange-related frictions could lead to different bitcoin prices across exchanges.

The Law of One Bitcoin Price?

Bitcoins are strictly homogenous: a bitcoin bought on one exchange is identical to a bitcoin bought on any other exchange. Therefore, any price differences across major bitcoin exchanges should be promptly eliminated by arbitrageurs buying bitcoin where it is less expensive and selling it where it is more expensive, thus enforcing the law of one price. However, the charts below show large differences between the prices of bitcoin-U.S. dollar transactions on three major exchanges: BTC-E, Bitfinex, and Bitstamp; the price difference between BTC-E and Bitfinex or Bitstamp, respectively, expressed as a percent of the BTC-E price, is persistently different from zero. The average difference is positive, indicating that bitcoins bought on BTC-E consistently trade at a discount relative to those bought on either Bitfinex or Bitstamp. This discount averages about 2 percent and has at times been higher than 20 percent.

Why Do Bitcoin Prices Differ across Exchanges?

Large, persistent deviations between pairs of identical assets are unusual in exchanges and, when they have occurred (as for so-called Siamese-twin stocks), they typically have not constituted profitable arbitrage opportunities. For bitcoin, an arbitrageur could, in theory, safely profit by buying bitcoin on BTC-E and then selling it or going short (by first borrowing bitcoin and then selling it) on either Bitstamp or Bitfinex. In reality, however, this trade would entail both transaction costs and/or risk (see the diagram below).

Transaction Costs

Transaction costs come in two forms: the bid-ask spread and trading fees. Since the arbitrageur must buy bitcoin on BTC-E at the higher “ask” price and then sell it on Bitstamp or Bitfinex at the lower “bid” price, the difference (the bid-ask spread) lowers the profits from trading. As shown in the price difference charts above, however, the bid-ask spread (as a percent of BTC-E price) in these exchanges is negligible relative to the typical price difference, and thus does not likely impede arbitrage significantly.

Other fees, however, represent more substantial barriers. BTC-E, for example, charges a 0.2 to 0.5 percent fee per transaction with additional fees to withdraw or deposit traditional currency (currently $20 for a wire deposit). Bitfinex and Bitstamp charge percentage trading fees and withdrawal/deposit fees as well. These fees reduce the profits from arbitrage, and may explain the observed price differences.

Risk

Bitcoin arbitrage opportunities across exchanges may also pose two risks: price changes due to delays in executing transactions and counterparty risk from exchange failure or fraud. In fact, bitcoin prices are volatile; the intraday volatility of the bitcoin price on BTC-E often exceeds the average price difference between it and Bitfinex (see chart below). Therefore, delays in executing trades imply that the price difference can shrink or even revert before an arbitrageur can exploit it.

The most significant delay is in the transfer of U.S. dollars into the exchanges. On BTC-E, where an arbitrageur needs to purchase bitcoin with dollars, deposits of U.S. dollars via wire take five to ten days. A trader wishing to execute this trade by transferring dollars to BTC-E faces significant risk of price changes over that period.

Another delay, although shorter, is the time needed to transfer bitcoin from BTC-E to either Bitstamp or Bitfinex. In order to deposit bitcoin for use on Bitstamp or Bitfinex, three network confirmations are required. Each confirmation takes ten minutes on average, so the delay between the purchase of bitcoin on BTC-E and its deposit on Bitstamp or Bitfinex is about thirty minutes. This shorter delay is avoidable by short selling, but shorting is only offered by Bitfinex and entails additional fees.

Exchange failure or fraud is another source of risk. Exchange failure is not merely a theoretical possibility in bitcoin markets—it occurs regularly. A study in 2013 reported that eighteen of the forty bitcoin exchanges analyzed—almost half—ultimately failed. Most notable among all bitcoin exchange failures is that of Mt. Gox, an exchange that once commanded the largest share of the market and lost roughly $460 million worth of its users’ bitcoin to hackers in 2014. Counterparty risk could help explain the consistent discount realized on BTC-E. Unlike Bitfinex and Bitstamp, BTC-E does not publish the location of its operations, and little is known about its owners. Such opacity may deter users from using the exchange for greater perceived probability of bankruptcy, which would endanger users’ accounts, or fraud.

Implications for Bitcoin as a Payments Alternative

While inter-exchange price differences in the bitcoin market are interesting examples of deviations from the law of one price, they also have broader implications for the attractiveness of bitcoin relative to other payment alternatives (primarily the traditional banking system). Since bitcoin does not serve as a unit of account, most users need to convert bitcoin back and forth with traditional currency on exchanges, subjecting them to “microstructure” frictions and inter-exchange price uncertainty. This price uncertainty, in turn, inhibits the use of bitcoin as a store of value. Thus, while bitcoin may continue to develop as an alternative means of payment, it competes with more traditional value-transfer methods on a familiar playing field—offering transfers with lower fees relative to transaction risk.

Authors: Alexander Kroeger and Asani Sarkar.