Federal Reserve Says Bitcoin Has 'Significant Friction'

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’

The 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.

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.

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.”

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