Bitcoin Microstructure and the Kimchi Premium.pdf

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Bitcoin Microstructure and the Kimchi Premium
Kyoung Jin Choi
∗
University of Calgary
Haskayne School of Business
Alfred Lehar
†
University of Calgary
Haskayne School of Business
Ryan Stauffer
‡
University of Calgary
Haskayne School of Business
this version: April 2019
Haskayne School of Business, University of Calgary, 2500 University Drive NW, Calgary, Alberta, Canada
T2N 1N4. e-mail: kjchoi@ucalgary.ca
†
e-mail: alfred.lehar@haskayne.ucalgary.ca
‡
e-mail: ryan.stauffer@haskayne.ucalgary.ca
∗
Electronic copy available at: https://ssrn.com/abstract=3189051
Bitcoin Microstructure and the Kimchi Premium
Abstract
Between January 2016 and February 2018, Bitcoin were in Korea on average 4.73%
more expensive than in the United States, a fact commonly referred to as the Kimchi pre-
mium. We argue that capital controls create frictions as well as amplify existing frictions
from the microstructure of the Bitcoin network that limit the ability of arbitrageurs to take
advantage of persistent price differences. We find that the Bitcoin premia are positively re-
lated to transaction costs, confirmation time in the blockchain, and to Bitcoin price volatility
in line with the idea that the delay and the associated price risk during the transaction period
make trades less attractive for risk averse arbitrageurs and hence allow prices to diverge. A
cross country comparison shows that Bitcoin tend to trade at higher prices in countries with
lower financial freedom. Finally unlike the prediction from the stock bubble literature, the
Kimchi premium is negatively related to the trading volume, which also suggests that the
Bitcoin microstructure is important to understand the Kimchi premium.
Keywords:
Bitcoin, Limits to Arbitrage, Cryptocurrencies, Fintech
Electronic copy available at: https://ssrn.com/abstract=3189051
1
Introduction
I think the internet is going to be one of the major forces for reducing the role of
government. The one thing that’s missing but that will soon be developed, is a
reliable e-cash.
Milton Friedman in 1999 - Nine years later, Bitcoin was created.
Many proponents of cryptocurrencies such as Bitcoin list independence from government
influence as key advantage of this new technology. In an ideal world, payments can be made and
funds exchanged globally without any central authority or government regulation.
1
Yet we argue
in this paper that government regulations in fiat currencies, especially capital controls, create
new and amplify existing frictions in the global Bitcoin market. In Korea, for example, Bitcoin
frequently trade at a higher price than in other markets, a phenomenon referred to as the Kimchi
premium. Between Between January 2016 and February 2018 the average Kimchi premium was
4.73% but it reached levels as high as 54.48% in January 2018. Figure 1 shows a time series plot
as well as a histogram of the historical Kimchi premium. In frictionless financial markets such
a price difference could not persist as it would be immediately arbitraged away. Traders could
buy Bitcoin in another market, say the US, then transfer them to a Korean Bitcoin exchange,
sell them for Korean won, and convert the won to US dollars for an instant profit. However,
institutional frictions prevent arbitrageurs from keeping Bitcoin prices in Korea aligned with
the rest of the world. Divergence in Bitcoin prices are not only a Korean phenomenon. As we
document in this paper, international differences in Bitcoin prices can be high and persist over
longer periods of time. Even within the US prices differ somewhat between exchanges.
2
In this
paper we analyze two main frictions that can contribute to a potential misalignment of Bitcoin
Satoshi Nakamoto, a pseudonym for the legendary inventor of Bitcoin, included the headline of the Financial
Times on Jan 3, 2009, “Chancellor on brink of second bailout for banks” in the first block, the genesis block, of the
Bitcoin Blockchain. Many see this as an expression of distrust in the current financial system. As the first reason
for the existence of Bitcoin, Bitcoin-Wiki states that ‘’Bitcoin is P2P electronic cash that is valuable over legacy
systems because of the monetary autonomy it brings to its users.”
2
Several websites allow users to monitor spreads and identify possible arbitrage opportunities: e.g.,
www.tokenspread.com, data.bitcoinity.org/markets/arbitrage. Figure 4 in the appendix shows such an arbitrage
matrix.
1
1
Electronic copy available at: https://ssrn.com/abstract=3189051
prices across major markets: capital controls and frictions emanating from the microstructure
of the Bitcoin network.
Due to microstructure of the Bitcoin network arbitrageurs are confronted with obstacles that
are absent in many traditional markets. An arbitrageur faces two main sources of risk when exe-
cuting the arbitrage trade described above. First, the transfer of Bitcoin from a foreign exchange
to a Korean exchange takes time during which the Bitcoin price can change dramatically. Since
Bitcoin can usually not be shorted in the markets where they are selling at a higher price the
premium cannot be locked in; Bitcoin at a Korean exchange can only be sold once the transfer is
complete. Because Bitcoin can be much more volatile than many transitional assets, price risk
can pose a significant deterrent for arbitrageurs. Second, time varying transaction costs erode
potential arbitrage profits. Demand for transactions fluctuates over the day and over time. As
fees increase, profits from arbitrage decrease allowing the price difference between Bitcoin in
Korea and the rest of the world to rise.
Frictions in traditional capital markets add limitations to arbitrage. Korean capital controls
limit the amount of money that can be sent abroad, or at least complicate the transfer of funds,
and thus create a one way friction for the fiat currency part of the arbitrage trade. In the af-
termath of the global financial crisis and the European sovereign debt crisis, Korea introduced
capital controls that create administrative burden and additional time delay when sending money
abroad.
Our main finding is that both Bitcoin microstructure effects as well as exchange controls
explain a significant portion of Kimchi premium. We start out with an in-depth comparison
of the Korean Bitcoin market with the European market where more detailed data is available
and markets are well developed and liquid. We find that in both markets microstructure effects
are correlated with price deviations. Price deviations relative to the US market are significantly
positively related to Bitcoin volatility, supporting the idea that price risk for traders limits arbi-
trage activity. The Kimchi premium is also positively related to the median confirmation time
in the block chain, supporting the idea that longer transaction times create more uncertainty for
2
Electronic copy available at: https://ssrn.com/abstract=3189051
Figure 1. The Bitcoin Kimchi Premium: Bitcoin frequently trade at a higher price in Korea than
in other markets.
The premium for purchasing Bitcoin with Korean won (KRW) versus US dollars
(USD) is calculated:
(KRWBTC
price in USD
)/(USDBTC
price
)
−
1,
where the Bitcoin price in USD is the
mean price of all USD transactions on the Bitstamp exchange for that day. The Bitcoin price in KRW is
similarly defined from the Korbit exchange. Conversion from KRW to USD is done using the OANDA
daily average rate.
a) The Kimchi premium over time (top panel)
b) Distribution of the Kimchi premium (bottom panel)
3
Electronic copy available at: https://ssrn.com/abstract=3189051

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