Federal Reserve Says Bitcoin Has ‘Significant Friction’

Federal Reserve Says Bitcoin Has ‘Significant Friction’

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Researchers from the New York Federal Reserve have issued a report on the digital currency Bitcoin. The study called “Is Bitcoin Really Frictionless?” uses some historical prices and arbitrage between three leading exchanges in the past. The analysis by the authors gives a detailed opinion on why there are different spot price ranges among each exchange concluding that the digital currency is not really frictionless.

Also read: Russian Firm Tries and Fails to Patent ‘Bitcoin’ Trademark

Federal Reserve Study Highlights ‘Unnatural Phenomenon’

Federal ReserveThe latest Federal Reserve research paper states that Bitcoin is the most popular cryptocurrency worldwide and can often take some friction out of the settlement process. This environment has removed the need for certain intermediaries according to the authors, though the digital currency encounters “significant friction” when passing through exchanges.

The blog post states:

[W]e 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.

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The blog post notes that wallet-to-wallet transactions are relatively free of settlement friction. However, when the currency enters the exchange ecosystem, it suffers from “large exchange rate volatility.”

This is problematic, the researcher believes, and it’s why many large companies who accept bitcoin convert to fiat immediately. The author gives the examples of Dell, Microsoft and Expedia along with their turnover rate with processors like Bitpay. Because these businesses hand over the currency to a third party, the funds are subject to more fees and counterparty risk.

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Risks described in the report mention significant losses like the bankruptcy of Mt. Gox and also delays in transfer. It also describes that the price between exchanges Bitfinex, Bitstamp, and BTC-e differs all the time, which is an unnatural phenomenon.

“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,” the authors explains.

But between these three exchanges and their recorded price ranges it’s actually quite the opposite. The report and the graphs below shows considerable differences “between the prices of bitcoin-U.S. dollar transactions on three major exchanges.”

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While the report states the price between exchanges is an “interesting example” of deviations, this may not be attractive to the traditional banking system. Bitcoin, therefore, cannot serve as a unit of account concludes the author and most users need to convert to fiat “subjecting them to ‘microstructure’ frictions.”

The NY Federal Reserve’s study demonstrates that the institution is researching the development of Bitcoin but believes its current arbitrage is an unnatural phenomenon. However, Bitcoin users could also interpret this as a sign of confidence that one of the largest issuers of money in the world is keeping a close eye on the virtual money as it progresses.

What do you think about the New York Fed’s blog post on Bitcoin? Let us know in the comments below.


Images courtesy of NewYorkFed.org, Shutterstock, Wiki Commons

  • Kevin Toal

    I wouldn’t call ~0.25% major differences.
    Ask the author why gold has different spot prices, or silver, or crude.. fact is, different markets have different prices,, due to market forces.
    In short, IMHO he is peddling a lot of hot air.

  • Romm333

    Bitcoin has friction due to the fact buying Bitcoin requires using an archaic form of money called FIAT. Buying Bitcoin with FIAT money slows down the whole process due to normal ACH protocols associate with physical currency.

    When FIAT is removed from the equation Bitcoin is instant.

    Quite funny the Federal Reserve thinks Bitcoin has friction when the only friction that exists is due to the Federal Reserve and their FIAT system.

    Bitcoin can be moved around the world instantly, FIAT takes days.

    • Paul Schmitzer

      There is also stricter KYC specific to bitcoin processors & exchanges; friction imposed on it by outside sources

  • Who arbs on high-fee exchanges and wires it out to re-cycle? Very 2013. Mean-reversion and leverage!

  • I think that the Ethereum system of smart contracts will steadily reduce bitcoins’ currency-exchange friction and possibly if not probably eliminate cryptocurrency exchanges altogether. After all, such exchanges are essentially a centralized add-on to a decentralized system — “a bag on the side” if you will. Or perhaps such exchanges will learn to incorporate Ethereum to survive. Or the banks will, ditto. In any case, it is likely that articles such as this one will increasingly have to incorporate Ethereum too. (And at the rate things are going, this may be the last one that doesn’t.)

    One evolving matter is the extent to which bitcoins will even be used as a point-of-sale currency except for remittances, gambling, and the Dark Web. It may be that the Bitcoin blockchain will increasingly be used for the more prosaic purposes of data registration and notary functions, probably also as a result of Ethereum. Right now such uses are in the slim minority, but that could change — expect the unexpected. But such an outcome could increase the price of bitcoins more steadily than their use as a nanosecond medium of exchange.

    • allenscott

      Ethereum has the same on-ramp problem as Bitcoin or any other crypto. In fact, it’s easier to buy bitcoin than ether with fiat as the former is usually converted to the latter.