Bitcoin Basics and Market Inefficiency

Probably the most common response I receive when I tell people about my summer research is something to the nature of “What is Bitcoin? I’ve heard of it, but I don’t understand it.” Probably the best way to describe Bitcoin is that it is a decentralized, digital currency. This simply means that there is no central authority (such as a central bank) controlling its worth (or lack thereof) like a normal fiat currency; and that, unlike Gold or Silver, a bitcoin is merely a line of code in a virtual ledger[1]. In other words, its value is derived purely from the expectations of investors it is valuable because it is accepted.

The question of course, is why is Bitcoin accepted by anyone? Bitcoin has several key features that make it particularly attractive to some individuals. The transactions are extremely secure, anonymous, and extremely fast (it takes roughly 10 minutes for the block chain to confirm the transactions)[2]. Bitcoins also are impossible to counterfeit given today’s computing technology and they can be divided into an infinite number of pieces when making a payment. This is a result of the Bitcoin “mining” process, which is what generates new Bitcoins. When a computer downloads and runs the Bitcoin Mining software, it is essentially just processing transactions from Bitcoin’s public ledger. Each computer participating has its own copy of the ledger (thus securing all transactions). Every time a computer processes a transaction, it is given a random number, if the number matches the one assigned for the entire “block” of transactions, the user (or pool of users combining their mining capabilities) is awarded 50 Bitcoins. As more bitcoins are mined, it becomes increasingly difficult to find a block (so don’t try mining them on your laptop, all you’ll get is an overheated computer).[3] While there are some accounting issues that may arise should one individual gain sufficient control of the mining process (such as a 51% attack where one malicious individual gains a majority of the mining power and uses it to alter the ledger), this type of attack is highly unlikely given the prohibitive cost (Bitcoin miners now have 13,000 times as much processing power as the world’s 500 largest supercomputers)[4]. Furthermore, the algorithm limits the number of bitcoins that can be generated. This makes bitcoins relatively scarce. However, because of the hard cap on total bitcoins in circulation, like gold-backed currencies, there are serious concerns about deflation in the long run[5]. Barring this, Bitcoin’s key features make it extremely attractive to a wide variety of individuals (such as libertarians, black market participants, and certain businesses).

My research is in Bitcoin’s ability to serve as an alternative investment. More specifically, I am examining whether Bitcoin can be used as an effective hedging tool against market volatility or if it could function as a stand-alone investment. So far, the research appears to be turning up some interesting results. One of the most significant results is that Bitcoin prices can vary wildly between different currencies and even different exchanges. After examining the average daily BTC exchange rate for 5 different currencies across multiple exchanges and comparing these results to average USD/BTC rates, it would appear there are still significant arbitrage opportunities between Bitcoin markets despite its increased acceptance. I am currently conducting additional testing to determine the cause of these inefficiencies. One factor that may explain these differences is liquidity. One of the trends I have noticed is that the largest arbitrage opportunities occur when BTC’s trading volume in one currency is significantly less than in USD.

As the summer comes to a close, I expect to discover additional factors leading to Bitcoin’s inefficiency within the coming weeks and I look forward to learning exactly what is driving these differences.

[1] http://www.coindesk.com/information/what-is-bitcoin/

[2] http://www.coindesk.com/information/how-do-bitcoin-transactions-work/

[3] http://www.economist.com/blogs/economist-explains/2015/01/economist-explains-11

[4] http://www.economist.com/blogs/economist-explains/2015/01/economist-explains-11

[5] http://www.theatlantic.com/business/archive/2013/12/why-bitcoin-will-never-be-a-currency-in-2-charts/282364/