Not all bitcoin are equal or: One dollar, two prices

A page from  Van Court's Bank Note Reporter and Counterfeit Detector (1843), showing multiple prices for various dollars. Notation: do=ditto, same as above | par=no discount | 20 = 20% discount | 1 = 1% discount | no sale = 100% discount | fail'd=failed bank, 100% discount | clos'd=bank closed, 100% discount

For the past year or so, US dollars deposited at the MtGox bitcoin exchange haven't been considered to be particularly good dollars. The problem is that they are illiquid. Due to a number of reasons (see Konrad Graf), MtGox has limited the ability of users to convert MtGox dollars into conventional dollars issued by the likes of Bank of America, Wells Fargo, and the US Federal Reserve. Withdrawals are slow, uncertain, and red tape abounds.

Current holders of "bad" MtGox dollars would very much like to make their dollar-denominated wealth more liquid. Unfortunately the only reliable route available to them is to exchange their bad MtGox dollars for someone else's bitcoin via MtGox's order book, then move these bitcoin off-exchange in order to purchase better and more liquid US dollars elsewhere. But why would a potential counterparty with spare bitcoin want to engage in this trade? After all, if they do then they'll only end up incurring the very same illiquidity risk that the original owner of MtGox dollars seems so desperate to offload. Better for the potential counterparty to sell their bitcoin for "good" (i.e. liquid) dollars at a competing exchange (like Bitstamp) that doesn't impose dollar redemption hassles.

In order for them to accept the burden of MtGox liquidity risk, potential purchasers of MtGox dollars must be cajoled into the trade by the promise of a large discount. Owners of MtGox dollars eager for bitcoin need to mark down the price at which they are offering their MtGox dollars, or, conversely, they need to mark up the price at which they will purchase bitcoin relative to the price at which it trades on other exchanges.

This, in short, is the most likely reason for the historical premium of MtGox bitcoin over bitcoin on other exchanges like Bitstamp and BTC-e , or, conversely, the discount of MtGox dollars relative to dollars on other exchanges. See the chart below, which shows how the MtGox USD/BTC rate has historically traded at a discount to the Bitstamp USD/BTC trade. (Note that I've flipped the traditional bitcoin price chart upside down to emphasize the dollar-side of the equation). In short, because they are relatively illiquid, MtGox dollars can't purchase as many bitcoin as Bitstamp dollars can.

Now as our chart shows, things have dramatically switched around, with MtGox USD/BTC recently flipping to a massive premium over Bitstamp USD/BTC. I'll get to that in a bit, but before I do so let's imagine the opposite situation to the one outlined above, a limitation on bitcoin withdrawals from MtGox. In this case things would tilt the opposite way. The only way to liberate wealth in the form of bitcoin from MtGox would be to buy MtGox dollars and withdraw them, then buy "good" bitcoin elsewhere. Counterparties would only agree to sell dollars for "bad" MtGox bitcoin if they were offered a steep discount on those coins. The price of MtGox bitcoin would have to be marked down relative to elsewhere, or, conversely, the price of MtGox dollars marked up relative to dollars elsewhere.

Let's imagine another scenario. What if redemptions of *both* MtGox bitcoin and MtGox dollars were halted or at least slowed? Put differently, what if both are equally bad, or illiquid?

In this case, an owner of MtGox bitcoin would see no benefit in offering to buy MtGox dollars at a premium since those dollars would be just as illiquid as bitcoin. Nor would an owner of MtGox dollars have any incentive to buy MtGox bitcoin at a premium, since those bitcoin would be just as unmarketable as dollars. The upshot is that the MtGox USD/BTC exchange rate would show neither a premium nor a deficit relative to the prevailing exchange rate on other markets.

However, the fact that we would no longer see any discrepancy in the MtGox USD/BTC exchange rate relative to the Bitstamp USD/BTC would not indicate that all is normal in the bitcoin universe. The freezing up of MtGox would reveal itself in a market we haven't considered yet: the MtGox USD/Bitstamp USD market. Presumably there is some sort of over-the-counter market on which trusted individuals directly swap the dollar deposits of one exchange for another. With MtGox freezing all withdrawals, we'd expect this exchange rate to be trading at a large deficit, investors willing to pay a much higher price to own liquid Bitstamp dollars. The same goes for the MtGox BTC/Bitstamp BTC market. Normally, this market would trade at par, since a bitcoin held on one exchange should be no different from a bitcoin at another. However, with MtGox frozen up investors would probably prefer to own liquid Bitstamp bitcoin and would pay a much higher price to do so.

Now let's get back to the inversion we see on our chart. There's been some interesting news in the bitcoin universe. It appears that MtGox bitcoin withdrawals have been halted, adding to the already-existing liquidity problems facing MtGox dollar owners. Peter Šurda gives more details here. As I pointed out above, if both bitcoin and dollars at MtGox have now been rendered equally illiquid then the MtGox USD/BTC ratio should not vary from prevailing USD/BTC ratio at exchanges like Bitstamp and BTC-e.

But what we've actually seen is a huge rise in the MtGox USD/BTC ratio relative to that of Bitstamp. The discount has become a premium. This would seem to indicate that though MtGox dollars are still relatively illiquid, they are more liquid than now-frozen MtGox bitcoin. Those with bitcoin-denominated wealth stuck in  MtGox desperately want to trade "terrible" MtGox bitcoin for "less terrible" MtGox dollars in order to flee. They are offering an incredibly high USD/BTC rate to tempt counterparties into taking the opposite—and more illiquid—side of this trade.

Now before you start shaking your head about the strangeness of modern cryptocurrency markets—"how weird is it to have multiple prices for the same money!" —note that we've seen this all before. In the first half of the 19th century, there was a bewildering quantity of different US dollar banknotes, with thousands of banks issuing their own brand. Prior to accepting a certain bill from a customer, a shopkeeper would consult his weekly Bank Note Reporter to determine what sort of discount or premium he should attach to the note.* (See the picture at top). In those days, notes were universally redeemable in a certain quantity of gold. What made things tricky was the fact that redemption could be easy or difficult, depending on how far away the issuing bank was. A note issued by a bank based in rural Pennsylvania and spent in South Carolina would have to take a circuitous and potentially expensive route back to its issuer prior to being cashed in for the metal. This resulted in those notes earning a higher discount. One dollar, multiple prices, was the norm back then.

Now compare MtGox to our rural Pennsylvanian bank. Given the long and circuitous route that both the banknote and the MtGox dollar must take prior to being "cashed out", they both trade at a large discount. Once again we have one dollar but multiple prices. Everything old is new again, it would seem.

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*If you're interested, Gary Gorton provides an introduction to Van Court's Bank Note Reporter and Counterfeit Detector (pdf)