Are bitcoin transactions really frictionless compared to traditional currency? Alexander Kroeger, a research analyst at the Federal Reserve Bank of New York’s Research and Startup Group, and Asani Sarkar, an assistant vice president at the bank’s Integrated Policy Analysis Group, analyzed bitcoin transactions and concluded that price differences across bitcoin exchanges and other factors create frictions that can impact market participants’ incentive to use bitcoin as a payment method.
The researchers presented their analysis on the Liberty Street Economics blog of the Federal Reserve Bank of New York.
While bitcoin transfers are relatively frictionless for the user, frictions do occur when bitcoins trade in exchange markets resulting in meaningful and persistent price differences across bitcoin exchanges. Such exchange-related frictions reduce market participants’ incentive to use bitcoin as a payments alternative.
Unlike traditional fiat currencies, there is no central authority governing bitcoin. Instead, bitcoin uses a mutually-agreed-upon set of code comprising the bitcoin protocol.
Proponents such as the Bitcoin Project claim the bitcoin protocol can reduce the time, fees, and risk associated with transferring value compared to traditional currencies. Payments submitted over the U.S. Automated Clearing House (ACH) network, for example, take as long as two business days to settle compared to 10 minutes typical for bitcoin payments.
Bitcoin has become accepted for payment by a variety of businesses and organizations. In March 2014, Bank of America filed a patent for a system to execute wire transfers using cryptocurrency exchanges to mediate between two sovereign currencies.
Transactions between digital wallets occur at a negligible cost relative to transaction amounts. But unlike traditional currencies, bitcoin does not serve as a widely-accepted unit of account. Hence, most users seeking to pay in bitcoin have to purchase it on exchanges using traditional currency.
After receiving bitcoin in a transaction, the user can hold it with the expectation of using it in a future transaction. But bitcoin’s exchange rate volatility and negligible correlation with traditional currencies compromise its usefulness as a unit of account or a store of value. Therefore, the bitcoin payee could be better off exchanging the bitcoin for traditional currency that is more useful as a unit of account.
Many large retailers, such as Microsoft, Dell and Expedia that accept payment in bitcoin, never actually receive any bitcoin. Instead, they use third parties that receive bitcoin from the customer and forward dollars to the retailer. The transaction from the traditional currency to bitcoin and back can entail transaction fees and counterparty risk. These exchange-related frictions, in turn, could result in different bitcoin prices across exchanges.
Because bitcoins are homogenous, price differences across bitcoin exchanges should be eliminated by arbitrageurs buying bitcoin where it is less expensive and selling it where it is more expensive, enforcing the law of one price. But large differences exist between the prices of bitcoin-U.S. dollar transactions on three major exchanges: Bitstamp , BTC-E. Bitfinex. The price difference between these exchanges expressed as a percent of the BTC-E price is never zero. The difference is positive on average, indicating that bitcoins bought on BTC-E trade at a discount compared to those bought on the other two exchanges.
The discount averages around 2 percent can exceed 20 percent.
Significant deviations between pairs of identical assets are unusual in exchanges. When they do occur (as for so-called Siamese-twin stocks), they have not delivered profitable arbitrage opportunities. A bitcoin arbitrageur could, in theory, buy bitcoin on BTC-E and sell it or go short (by first borrowing bitcoin and then selling it) on one of the other exchanges and make a profit. But in reality, this trade entails both transaction costs and risk.
Transaction costs occur in two forms: trading fees and the bid-ask spread. Because the arbitrageur has to buy bitcoin on BTC-E at a higher “ask” price and then sell it on at the lower “bid” price, the bid-ask spread reduces the profits from trading. However, the spread (as a percent of BTC-E price) in these exchanges is negligible in relation to the normal price difference. Hence, it is not likely to significantly impede arbitrage.
But other fees represent more substantial barriers. BTC-E charges a 0.2 to 0.5 percent fee per transaction along with fees to deposit or withdraw traditional currency. There is currently a $20 fee for a wire deposit. Bitstamp and Bitfinex also charge trading fees and deposit/withdrawal/fees. Such fees lower the profits from arbitrage, and could explain the price differences.
The arbitrage opportunities across bitcoin exchanges can pose additional risks. Delays in executing transactions and counterparty risk from exchange fraud or failure can cause price changes. Bitcoin prices are volatile; BTC-E’s intraday volatility of the bitcoin price often exceeds the average price difference between it and Bitfinex. As a result, delays in trade execution mean the price difference can decline or revert before an arbitrageur can exploit it.
The biggest delay is in the transfer of U.S. dollars to the exchanges. For an arbitrageur purchasing bitcoin with dollars on BTC-E, depositing U.S. dollars via wire takes five to 10 days. The trader seeking to execute this trade by transferring dollars to BTC-E faces significant risk price change risk over that period.
There is also a delay in transferring bitcoin from BTC-E to the other two exchanges. Depositing bitcoin to one of these exchanges takes three network confirmations, each of which takes an average of 10 minutes. This results in a 30-minute delay between buying bitcoin on BTC-E and depositing it on Bitfinex or Bitstamp. This delay can be avoided by short selling, but only Bitfinex offers short selling, for which it charges additional fees.
Another risk is exchange fraud or failure. Exchange failure occurs regularly. A 2013 study reported that 18 of the 40 bitcoin exchanges analyzed ultimately failed. Mt Gox was the most notable failure.
Counterparty risk might explain the discount consistently realized on BTC-E. Unlike Bitstamp and Bitfinex, BTC-E does not publish its operating location, and not much is known about its owners. Such opacity could discourage users from using the exchange due to fear of fraud or bankruptcy.
While inter-exchange price differences provide interesting examples of deviations from the law of one price, they have broader implications for the attractiveness of bitcoin compared to other payment alternatives.
Because bitcoin does not serve as a unit of account, users must convert bitcoin into traditional currency on exchanges, which subjects them to “microstructure” frictions and inter-exchange price uncertainty. Price uncertainty, in turn, hinders the use of bitcoin as a store of value.
Hence, while bitcoin may continue to evolve as an alternative payment method, it competes with traditional value-transfer methods on a familiar playing field—providing transfers with lower fees relative to transaction risk.
Featured image from Shutterstock. Chart from NY Fed Reserve Blog.
Last modified: March 4, 2021 4:47 PM