Wednesday, March 23, 2016

New York Fed On Bitcoin

From the Federal Reserve Bank Of New York's Liberty Street Economics blog:

Is Bitcoin Really Frictionless?

The Case for Bitcoin
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.  
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....MORE