Bitcoin Series Addendum - Market Structure

Summary

• In my previous Bitcoin series, I left out an important detail.
• It concerns the market structure, which has become very relevant in the last few days.
• This article describes the implications for investors and what they can do about it.

I had thought my Bitcoin series, starting with "Bitcoin Series #1 - The Basics," was pretty comprehensive. However, it appears as if I forgot to include something very important. This "something" has actually been showing its extreme effects during the last few days.

What I forgot to include is Bitcoin's market structure. What do I mean by that? Well, overwhelmingly, bitcoin is traded on bitcoin exchanges. There are thousands of these markets, but within those, a few are a lot more relevant than others. For instance, these were the markets with the highest volume in the last 24 hours:

Source: Coinmarketcap.com

So here's the thing: Each of these markets does not communicate with the others. What does this mean? It means that buyers/sellers on each exchange are reliant on bids/asks exclusively from other members trading on the very same exchange.

Now, that doesn't seem all that different from what happens with stocks in countries like the U.S., with all kinds of markets and ECNs, does it? But it really is massively different.

That's because with stocks, a broker can quickly reroute his orders from one exchange to the other. The depositary/custodian of his stockholdings is not the exchange. With bitcoin, it's different. The exchange is also the depositary of one's bitcoin holdings (at least when they're primed to be traded). And to reroute their selling orders from one exchange to the next, investors would have to:

• Withdraw their bitcoin from one exchange's wallet to their own wallet.
• Deposit their bitcoin from their wallet into the other exchange's wallet.

With bitcoin, these things take a lot of time (and some expense). Just to get their bitcoin from the first exchange, and beyond any timing overhead for exchange processing, investors (and the exchange) will need confirmation that the transaction has been committed to the Bitcoin blockchain. That takes up to 10 minutes to appear in the first block (if the paid transaction fees are high enough). But a 1 block confirmation is too risky for the exchange or the investors to fully trust it. More likely, both will wait until the confirmation is 6 blocks old. That's up to one hour.

Then, to deposit their bitcoin on the second exchange, the same thing happens. Even ignoring any exchange overhead, the investors and the exchange will both require confirmations similar to the first withdrawal. So that's another hour. As a result, instead of the instant rerouting, which happens with stocks, the Bitcoin investor is exposed to up to a two-hour wait (considering no overhead elsewhere). Of course, two hours in the Bitcoin world is eternity.

The Result?

The result of this highly inefficient market structure is that the same asset (Bitcoin) trades at significantly different prices from exchange to exchange. For instance, as I type this, bitcoin is priced at:

• $16,779 on Coinbase
• $15,497 on Bitstamp
• $15,498 on BTC-e
• $15,300 on Bitfinex
• $15,698 on Gemini

So there you have it. There is seemingly a massive inflow of new customers into Coinbase. They can't help but be opening new accounts to buy bitcoin. As they buy, they hit into the limited supply provided singly by other Coinbase customers. The result is a massive premium. This market structure and resulting price distortion have many possible implications.

Arbitrage

One of the implications is that it's possible to conduct arbitrage between several exchanges. However, this arbitrage is exposed to the timing problems described before, so it's far from risk-free. Still, it's possible to buy bitcoin on several other exchanges just to sell it on Coinbase. Indeed, this is likely happening and containing the premium, otherwise who knows how high bitcoin on Coinbase would already be.

Moreover, it's possible to arbitrage over and over. Buy on another exchange, sell on Coinbase - rinse and repeat. However, the selling would have to be made to another Altcoin. If the selling was done into USD, Coinbase would likely limit how much money could be withdrawn and how fast. Again, another inefficiency vs. a typical stock market.

Straight Selling at a Better Price

Another implication is simply that any rational bitcoin seller ought to open an account at Coinbase and sell there. He or she will get a higher price for the same goods.

Price-Insensitive Buyers

There's yet another implication. The buyers pressuring bitcoin massively higher on Coinbase need to be totally price-insensitive. Or totally unaware of the market structure. Or both.

There is no other possible explanation. The exchange being more trustworthy cannot explain the differential to nearly all other exchanges, and Coinbase hasn't exactly been that safe for its customers either (there are numerous reports of stolen bitcoin). They're choosing to pay a much higher price for the same asset, when they could easily buy the same thing cheaper. Indeed, were it not for the arbitrage mechanisms I described, they'd probably (and happily) pay higher still.

Market Impact

There is yet another implication. Liquidity on the bitcoin market is fractured across markets. This goes for the supply of bitcoins when it comes to a great euphoria, such as the one happening at Coinbase right now. But it will also run in reverse when the market hits selling. That is, when sellers want out, they'll be limited by the willingness to buy from each exchange's customer base.

More than likely, this will imply that when selling hits, there will be a giant void at some point. Without circuit breakers, either the exchange arbitrarily disconnects trading or at some point it's very likely we'll see a "no bid" market. I've seen such a market once in my life, in Portuguese equities. This was a stock market that did not have the flaws bitcoin exchanges exhibit. The odds of us seeing such an event under this particular market structure and with this asset are very high. Indeed, they're not even unprecedented for Coinbase itself. It already saw such an event happen with Ethereum.

Three More Things

I want to add three more things here:

• The whole market is pricing Bitcoin against a very limited supply of bitcoin on any single exchange.
• An exchange does not need to have cash reserves to buy anyone's bitcoin. This is a common misconception. The exchange only needs to list buy orders for its customers, who have funds deposited with the exchange to make good on such orders.
• It might pay to have both sell orders placed at stupidly high prices and buy orders at stupidly low prices given the market structure described. However, I wouldn't be surprised if exchanges arbitrarily cancelled such orders (especially the buy orders) if executed. Someone placing these orders might want to document them clearly and read all contract terms to see if the exchange has the power to cancel them after the fact. If not, it likely would result in a situation that could lead to successful lawsuits if cancelled.

Conclusion

There are several conclusions to be made here:

• The bitcoin/cryptocurrency market structure is creating extreme pricing distortions between exchanges, and also contributing to the strong up move being seen.
• This has many implications for traders within this market, which can maximize their sell prices or produce arbitrage gains by exploiting the evident market structure flaws.
• Arbitrage is not risk-free because of the Bitcoin flaws implying long times to switch currency from one exchange to the other.
• The distortions also show the nature of the buyers coming into the market right now: They are both price-insensitive and likely unaware of the market structure and pricing differentials. This is consistent with strong bubble behavior.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.