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:
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:
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 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:
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.
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.
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.
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.
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.
I want to add three more things here:
There are several conclusions to be made here:
This article was written by
I am a Portuguese independent trader, analyst and algorithmic trading expert, having worked for both sell side (brokerage) and buy side (fund management) institutions. I've been trading professionally for about 20 years.
I have a Marketplace service here on Seeking Alpha called Idea Generator that's focused on real-time actionable ideas based on valuation and catalysts. The Idea Generator portfolio has beaten the S&P 500 by more than 24% since inception (in 2015).
I also launched www.thinkfn.com in 2004. Thinkfn (Think Finance) carries thousands of educational articles on finance and markets (in Portuguese).
I trade futures, stocks from the long and short side, forex and options. I trade both discretionary and fully automated systems (Metatrader, Quantshare and others). I can be reached at paulo.santosATthinkfn.com or followed on Twitter at twitter.com/ThinkFinance999
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.