The Federal Reserve Bank of New York asks if bitcoin is really frictionless

In a article by the Federal Reserve Bank of New York, they did a write up on bitcoin and how it holds up as a virtual currency, covering in some detail bitcoin exchange options and opportunities such as arbitrage, and it’s advantages and disadvantages in using bitcoin over other more traditional currencies.

Is bitcoin frictionless?

In the post three well known bitcoin exchanges are covered: BTC-e, Bitstamp, and BitFinex. They discuss how users who wish to use bitcoin, need to enter in typically through a bitcoin exchange, using traditional currencies such as the dollar or euro as their payment gateway in-and-out of bitcoin. It’s also explained in part of how the price of bitcoin gets it value, including arbitrageurs who want to trade bitcoin for profit.

The Fed writes,

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.

They go on to explain that even though there are arbitrage opportunities, there are costs involved which create friction, such as exchange spread fees and trading (transaction) fees. Due to the different fees, arbitrage is less appealing, but not out of the question. The Fed also said that bitcoin price volatility is an issue, since getting in-and-out of bitcoin with dollars or euros can take an excessive amount of time for ACH or bank wires.

In addition, the issue of counter-party risk in exchanges poses a question to those who may be unwary of bitcoin and the general feel of the market and past occurrences, such as the Mt.Gox debacle two years ago, which many are still reeling from.

Overall, the Fed asserts from their article that bitcoin is not frictionless, because of users who want to trade bitcoin on exchanges and the challenges that are faced with bitcoin trading. However, they fail to come to the conclusion the issues causing the main challenges in bitcoin trading are the fiat gateways going in-and-out of bitcoin, as they mentioned in the article. Time delays aren’t faced when trading bitcoin-to-bitcoin, it’s only when dealing with fiat currency where long delays are presented; bitcoin in essence solves this when not going in-and-out of government money, as explained by the Fed in the article which highlights one of the advantages of bitcoin, fast settlement times of ~10 minutes for a single transaction.

It’s also worth noting that the ideology that bitcoin is “frictionless” doesn’t come from those who wish to trade bitcoin for fiat and vice versa, the value added by bitcoin is when users stay within bitcoin. When performing bitcoin-to-bitcoin transactions, there is no friction, and value can be transferred from one person in the world to another in seconds without the need of a central authority, such as a bank.