Exchange bankruptcy priced into Bitcoin?

Currently we are witnessing the “gold rush” era of decentralized virtual money. Bitcoin was only recently invented, and while it’s possible to sense its significance, exactly for what purpose and how the technology will be used are still rather unclear. Bitcoin infrastructure is taking shape now, and businesses and institutions based on it are being developed. That’s a rocky road, since everything is new, unregulated and undeveloped, and it’s not even clear what direction things should take. Companies that position themselves well now and are smarter than the others or are better at predicting what direction it will take stand to make a massive profit, while many will fail. We can get an inkling of such potential failure from the current pricing of Bitcoin. Below I’ll explain what I mean.

The Bitcoin price on the exchange with the largest volume, Mt. Gox, now exceeds by 15% the price on the second largest exchange (Bitstamp). Since these online marketplaces are far from perfect, and are slow, expensive and unreliable compared to traditional, supervised exchanges, there have been pricing differences of a few percent in the past too. However, a few weeks ago the spread began to increase and now it is incredibly large, as the figure below shows.

Has it not occurred to anyone to arbitrage such a huge difference? Of course it has, but despite that the spread has kept on growing. How is that possible? Arbitrage should eliminate the pricing difference, not increase it. There must be another, more significant impact. What could that be?

Mt. Gox hasn’t had the smoothest of years. It hasn’t been all bad news: the price of Bitcoin and volume soared, meaning that their commission revenues rocketed. On the other hand, it was hit with a high-value lawsuit and required to engage in costly licensing processes. But most worrying in the short term is that its US accounts have been frozen.

While we don’t know exactly how much money was kept on those accounts, it seems probable that liquidity problems have arisen recently as a result. And, as tends to be the case, it’s the customers that get the raw end of the deal. Money withdrawals started to be delayed. The exchange claims that the delays are due to the increased number of withdrawal requests and it cannot cope with the massive quantity of data, but I don’t believe that. One thing is sure: currently it takes at least several weeks for money withdrawn from Mt. Gox to arrive. The real question, in my opinion, is whether the money will arrive at all.

There is, however, another smarter, quicker and more reliable way of withdrawing money from Mt. Gox, though it’s more costly. Rather than transferring money held at the exchange in dollars (since such withdrawals will not be made for weeks and perhaps even never), it is possible to purchase Bitcoins with the money and transfer them to an account held at another Bitcoin exchange. Those Bitcoins can then be sold at the other exchange, and the dollars received in exchange can be transferred to a bank account. The method works since Bitcoin transfers are still functioning smoothly and being made immediately from Mt. Gox. No authority can freeze Bitcoin accounts – which is one reason for liking Bitcoin – and the Bitcoins are there and accessible, since the company doesn’t have any liquidity troubles in that regard. Bitcoin transfers arrive within 1 hour – another reason for liking Bitcoin – unlike international dollar transfers, which can take several days. The other large Bitcoin exchange, Bitstamp, does not have any liquidity problems and dollar withdrawals from there are not experiencing delays. Increasing numbers of people are doubtless choosing this method of freeing their money that is stuck on Mt. Gox.

The result, however, is that there is extra Bitcoin demand at Mt. Gox, and extra supply at Bitstamp, which has led to an increase in the difference in Bitcoin prices between the two exchanges in Mt. Gox’s favour. The Bitcoin price is usually identified as the Mt. Gox price (since it’s the exchange with the largest volume), but that’s a huge mistake in the current situation. Comparing the Bitcoin price of approx. 120 USD at Mt. Gox to the approx. 105 USD price at Bitstamp, all we can claim is that 120 USD deposited with Mt. Gox is currently worth approx 105 USD on the market, because we can’t be totally sure whether we still have our money. Meanwhile, the real price of Bitcoin is at around 105 USD. Of course those numbers can change rapidly.

Original date of Hungarian publication: 21 August 2013