Do Bitcoins Violate a Fundamental Economic Law?

Want to buy a bitcoin?

If you click over to Mt. Gox, the most famous bitcoin exchange, one unit of the crypto-currency will set you back $145. But at Bitstamp you would pay only $129. (At time of writing; prices can change quickly.)

Mt. Gox traders are thus paying a 12% premium for their bitcoins.

That spread seems to violate a fundamental economic law. When transaction costs are low, identical items should trade at nearly identical prices. Otherwise, arbitrageurs would step in to buy cheap and sell dear until the price gap narrows.

But that isn’t happening.

The “law of one price” used to hold. Last fall and winter bitcoin prices at the two big exchanges typically differed by less than 2 percent, a reasonable range given exchange fees and the cost of money transfers (click here if you don’t see the chart or want it bigger):

Bitcoin Spread

In April, however, the bitcoin market went haywire. After spiking to $266 on Mt. Gox, bitcoin prices cratered, falling as low as $54 just two days later. That volatility created large, but temporary spreads between prices on different exchanges (and made it difficult to measure spreads accurately).

When conditions calmed, spreads returned to normal. And then Mt. Gox’s troubles began.

On May 14 the U.S. government accused the exchange of operating an illegal money service business. The government seized $5 million that Mt. Gox held at Dwolla (an online payment processor) and Wells Fargo.

Fearing for their money, Mt. Gox customers converted their at-risk dollars into easy-to-withdraw bitcoins, and the Mt. Gox-Bitstamp spread spiked to 5%.

Spreads briefly normalized until Mt. Gox announced that it was suspending U.S. dollar withdrawals. Mt. Gox had become a Roach Motel (or, if you prefer, a Hotel California) for U.S. dollars. Traders could check their dollars in, but they couldn’t check them out.

Customers responded as you would expect. The spread spiked to 6%, as Mt. Gox traders again converted dollars into bitcoins. The spread briefly narrowed after Mt. Gox’s July 4 announcement of resumed dollar withdrawals. But spreads then spiked to record levels once Mt. Gox customers started reporting that withdrawals remained slow or nonexistent.

Mt. Gox prices are higher than on Bitstamp today because customers apparently can’t get their dollars out of Mt. Gox. So they pay extra for bitcoins. For those customers, a Mt. Gox bitcoin is different from one anywhere else. So the Mt. Gox price isn’t a clean measure of a bitcoin’s value. Instead, it measures the value of a bitcoin plus the desperation of Mt. Gox’s customers.

But that still leaves a puzzle. It makes sense that customers will pay a premium to get their money out. But who is willing to take the other side of the trade, selling bitcoins in return for “Mt. Gox dollars”?

As best as I can tell, those traders have stayed silent on the bitcoin chat boards. Perhaps they are newcomers who think they’ve found an arbitrage opportunity and don’t realize their dollars will be hard to withdraw. Or perhaps they believe that Mt. Gox will get its act together. (A more sinister take, raised on the boards, is that some preferred traders do have the ability to withdraw.) Whatever the case, they stand to make a tidy profit if they can get their dollars out, and sorely disappointed if they can’t.

Sources: For a quick explanation of bitcoin, try this introduction. For price data from numerous exchanges, visit bitcoin charts. My chart uses a 7-day moving average of spreads to smooth the volatility. The measured spread has at times been much higher, e.g., 40%+ on April 10, but that passed quickly.

Disclosure: I own 0.1 bitcoin.

15 thoughts on “Do Bitcoins Violate a Fundamental Economic Law?”

  1. These gyrations are all entertaining, but can anyone explain to me why bit coins are not a Ponzi scheme? It seems to me that with their thoroughly opaque origin, they have all the qualifications, and somewhere a creator has already cashed out and is just laughing at everybody else.

    1. This comes up often in bitcoin-land. Here’s one explanation: https://bitcointalk.org/?topic=7815.0

      Certainly not a Ponzi scheme in the traditional sense of taking in money from newbies in order to pay off high returns to a smaller group of prior investors. Could be a bubble — newbies coming in because the price has risen independent of fundamentals. Of course, bitcoin fundamentals are rather hard to pin down.

  2. I would think that it’s less that bitcoins have different value at different exchanges, but that dollars have different value at different exchanges. And even that wouldn’t violate a fundamental economic law, as claims for dollars from one particular company or another isn’t quite the same thing as a claim for dollars from an FDIC-bank. When one has $100 in Mt.-Gox-dollars, that’s different from having a $100 bill in one’s hands.

    1. That’s a good way to look at it. Mt. Gox dollars are currently worth less than regular ones. So the Mt. Gox bitcoin price is actually the price in Mt. Gox dollars, not regular ones.

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  4. I used to be a currency arb trader on the Dollar Index (at the World Trade) so I think I should be able to follow this but I seem to be missing something….”Fearing for their money, Mt. Gox customers converted their at-risk dollars into easy-to-withdraw bitcoins” What exactly “at risk dollars” does Donald mean here? Why would Mt. Gox customers have unconverted dollars just sitting in Mt. Gox accounts? Well, perhaps I do see, but would like a clear explanation. Thanks

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