What makes money special, the lawyer's edition (with a guest appearance by bitcoin)

Juan Galt recently introduced me to one of bitcoin's biggest problems. Bitcoin is not money, at least not according to the law.

Economists like to say that money is unique because it is a medium of exchange, store of value, and unit of account. Lawyers and judges have a different story to tell about money's uniqueness. Unlike goods, money can't be 'followed.' When a good is exchanged, its entire history goes with it. This history may be checkered. Say that a car has been stolen at some point in its past and then sold, and the police discover this fact. The current owner—though having purchased the car innocently—is required to return it to its rightful owner. The law 'follows' goods.

With money things are different. Each time a monetary instrument is transferred, its history is wiped clean. As long as the recipient accepts the money in good faith, the original owner of stolen dollars cannot make a claim for those dollars.

This peculiar legal treatment of money, dubbed money's liability limitation by Steve Randy Waldman, ensures fungibility. When all members of a population can be perfectly substituted for each other, than we say that they are fungible. If each monetary unit's unique history becomes a datum that merchants must take into account before selling a good, then fungibility no longer prevails. One unit may be worth more than another because its history is more pristine.

Fungibility is important because it promotes the smooth functioning of a monetary system. If merchants have to analyze each piece of money they are offered to ascertain its legitimacy, long lineups will develop. Exchange grinds to a halt.

So why not extend the status enjoyed by current forms of money to bitcoin? What follows is a quick tour through the history of how jurists have rationalized the legal treatment of other forms of money, including coins, banknotes, and bills of exchange. This should provide us with enough grist to analyze bitcoin's current legal status.

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Let's start with coins. The basic principle of nemo dat quod non habet governs property; no one can give away that which they do not have. According to early common law jurists, coins were exempt from nemo dat because they couldn't be followed. The inability to follow coins arose from the fact that they were homogeneous. In the words of the jurists of the day, 'money has no earmark.' Whereas one pig could be differentiated from another thanks to the practice of earmarking—cutting out a distinct piece from a pig's ear—coins could not be earmarked, and therefore could not be differentiated.

Thus there was no way for a victim to lay claim to lost or stolen coins. With no way to prove that the coins in the accused's pockets had not already been there, mixed coins could not be sufficiently distinguished to establish title. James Fox, for instance, cites a 1614 case in which a gambler, Warde, "thrusts" his coins into the stack of another gambler, Aeyre, perhaps hoping to get a tell from of his opponent. Aeyre refuses to give the coins back. The judge upholds Aeyre's rights to the entire stash since money has no earmark, and therefore nemo dat does not apply. Once mixed, who ever possesses the pile of coins has the best title.

Interestingly, the only way to preserve ownership of coins in the medieval era was to keep them in a bag. Since they could now be identified by the distinctiveness of their container, like any other good they were subject to nemo dat. Had Aeyre's coins been bagged, he could have easily mixed them with Warde's without losing title to them.

The fact that coins had no earmark meant that each piece's distinct past was irrelevant. While this was awkward for poor Aeyre, society was made better off by this decision. Coins became much more fungible than they otherwise would have been, and this would have dramatically promoted their use in trade, greasing the wheels of commerce in general.

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Let's move on to paper credit, namely bills of exchange and banknotes. While bills of exchange developed in the 12th or 13th century, the first notes would not have appeared in England until the 17th century. Though English common law was useful for land disputes, it had not yet developed the expertise to deal with commercial disputes. Indeed, common lawyers' expertise with commercial matters was so limited that Josiah Child, an English trader, complained that he could only make his lawyers understand "one half of our case, we being amongst them as in a Foreign Country."

Rather than resorting to common law, problems arising from the usage of negotiable instruments like bills were governed by lex mercatoria, or merchant's law, a private form of commercial law or custom that had been developed by European merchants over the preceding centuries. Market courts, operated by the merchants themselves, guaranteed a decision the day after a complaint, a necessity given the mobile nature of commercial life.

According to Lowry, the close-knitted nature of the merchant class began to unravel by the end of the seventeenth century, making merchant law less enforceable. As commercial cases were increasingly brought to common law courts, jurists had to decide how to treat these new financial innovations.

Lex mercatoria had always accepted the principle that, as in the case of coins, bills of exchange could not be followed. Since those who accepted bills of exchange didn't have worry about whether they had been stolen or not, this would have made trade in bills of exchange extremely fluid. However, the stance taken by lex mercatoria was an anathema to common law logic. Unlike coins, which couldn't be followed due to their lack of earmark, both bills of exchange and banknotes did have earmarks. Whereas coins were issued in uniform denominations, bills of exchange were usually made out in non-standard ones, say $101.50, making for easy identification. Bills were also signed by a unique debtor and a range of consignees. As for banknotes, these had serial numbers on them. Without the homogeneity of coins, there seemed to be no way to save the these relatively new financial instruments from the harsh strictures of common law nemo dat. Goods they were to be, not money.

It was Lord Mansfield, an English jurist, who took on the task of incorporating lex mercatoria into English common law (Adam Back notes a similar case in Scotland). Take Miller v Race, Mansfield's definitive ruling on banknotes in 1758. The note in question had been issued by the Bank of England "to William Finney or bearer on demand" and subsequently mailed to a third party by Finney. Along the way it was stolen and used to buy room and board at an inn, the innkeeper Miller innocently accepting the note. Finney, upon learning of the robbery, asked Race, an employee at the Bank of England, to stop payment of the note, upon which Miller the innkeeper sued Race. If the bill was treated as a regular good, then Finney would have prevailed. However, Mansfield ruled that despite the note having been stolen, Miller had the best title and was allowed to keep it.

In justifying his ruling, Mansfield dismissed as "quaint" the old earmark principle for not following money. Instead, he appealed to the common mercantile practice of the day. Banknotes, wrote Mansfield, are:

not goods, nor securities, nor documents for debts, nor are so esteemed; but are treated as money, as cash, in the ordinary course and transactions of business, by the general consent of mankind, which gives them the credit and currency of money to all intents and purposes. The are as much money as guineas themselves are, or any other current coins that is used in common payment as money or cash. 

The true reason that money cannot be followed, said Mansfield, is upon "the currency of it; it can not be recovered after it has passed in currency." Thus had Finney sued the robber before he had spent the stolen note, he would have succeeded in claiming title since the note had not yet passed into currency. But once Miller accepted it, the note was "in currency" and thus out of nemo dat's reach. In subsequent rulings, Mansfield extended this same protection to bills of exchange, cheques, bonds, and exchequer bills. Any contrary decision would "incommode" trade and commerce, wrote Mansfield. Thus the customs of merchants were transcribed into common law.

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So both lex mercatoria and the common law tradition that superseded it accepted the principle that in order to protect commerce, highly liquid instruments should not be subject to nemo dat.  Given this precedent, why not extend this same broad amnesty to modern monetary innovations like bitcoin, Fedcoin, or other digital bearer tokens?

One reason could be that bitcoin hasn't proven itself yet. Whereas bills of exchange and banknotes had been widely accepted for decades, even centuries prior to Mansfield's ruling, bitcoin is less than a decade old. It fails the my-grandmother-uses-it-test or, in Mansfield's words, lacks the "general consent of mankind." People seem more intent on hoarding the stuff than trading it around in the "ordinary course of business." Unfortunately there is a chicken-and-egg dynamic at play here; how can bitcoin gain enough consent to be granted amnesty by the law if it needs amnesty to gain consent in the first place?

Lacking common law amnesty from nemo dat, an alternative would be to modify bitcoin so that it is completely anonymous. Although it is true that the real world identity of a bitcoin owner remains unknown, the blockchain itself is a publicly-distributed ledger that reveals the history of every single bitcoin. Removing the ability to see the ledger's history would restore true anonymity. In the same way that coins were originally exempt from nemo dat because they were physically impossible to follow, modern law would not be able to trace any given bitcoin because there would be no means to do so. Anonymity in turn guarantees fungibility, without which mass market adoption might never happen. My understanding is that extensions such as Zerocoin or Zerocash would be able to achieve this sort of true anonymity.

The third route is to roll with the punches and accept non-fungibility. If merchants must search each bitcoin's past, they will innovate solutions to cope. One innovation would be to set up a system for grading bitcoin so as to save on transaction time. Tokens that pass a test of authenticity would be accepted at par whereas low grade bitcoin, that which has a soiled history, would pass at a large discount to pure bitcoin. I believe that a few bitcoin grading services have emerged, including Mint Exchange, which sells freshly-mined bitcoin (which are unburdened by a history) at a premium to regular bitcoin.

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Let's explore the third route a bit more. There is precedent for non-fungible monetary systems. During the so-called Wildcat banking era in the early to mid 1800s, U.S. privately-issued banknotes of the same denomination (say $1) were often  accepted at varying discounts to par. A $10 note from a the Bank of Talahassee might only be worth 98% that of a $10 note from the Bank of Fargo.

While banking regulations prevented note-issuing banks from establishing branches beyond state borders, nothing kept their notes from circulating outside of their home state. However, for notes to be settled in gold, they had to be returned to the issuing bank. Given the large distances involved and lack of transportation infrastructure, this could be an expensive process. To recoup this cost a merchant would typically accept local notes at par while applying discounts to non-local notes. The discount acted as a fee that covered the merchant's transportation costs. And since each bank's brand of notes involved different transportation costs, there were a bewildering number of discounts.

To solve the non-fungibility problem, a new profession emerged, that of a banknote analyst. In addition to providing merchants with information on how to spot counterfeit bank notes, an analyst would publish a weekly banknote reporter that advertised the market price of each banknote that circulated in a particular city, say Philadelphia. Gary Gorton provides a visual feel for what one looks like. Philadelphian merchants who subscribed would, upon being proffered a particular note by a customer, consult their reporter and apply the proper discount. I've explained in more depth how this process worked here and here.

While a Wildcat-era sorting mechanism for bitcoins would help merchants cope with the fungibility problem, any sort of grading process would also impose an extra set of costs on the bitcoin system, making it less competitive with banknotes and deposits. The lack of uniformity of U.S. banknotes was recognized to be enough of a problem that the 1864 National Banking Acts required all banks to accept notes at par (it would have been better to allow banks to establish branches across state lines, of course. See George Selgin here).

Uniformity would certainly be the most efficient solution for bitcoin, but lacking a central authority that can enforce par acceptance, bitcoin may have to endure a period of non-fungibility before the law deems the cryptocurrency popular enough to earn amnesty from nemo dat. That's a low bar to set, but if bitcoin is as good as its proponents say, it should be a bar that can be limbo-ed.


Sources:

S. Todd Lowry: "Lord Mansfield and the Law Merchant: Law and Economics in the Eighteenth Century" (1973) [link]
Benjamin Geva: "The Payment Order of Antiquity and the Middle Ages" (2011)
Kenneth Reid: "Banknotes and their Vindication in Eighteenth-Century Scotland" (2013) [link]
David Fox: "Banks v Whetston" in Landmark Cases in Property Law (2015)
Tim Swanson: Unable to dynamically match supply with demand (2015)
Nick Szabo: From Contracts to Money (2006)

How monetary systems cope with a multitude of dollars

Over the last few decades, dollars have become incredibly heterogeneous. People can pay for stuff with traditional paper bank notes, debit cards, or a plethora of different credit cards. Each of these dollar brands comes with its own set of services and related costs. On the no frills side is cash. Paying with paper still incurs the lowest transaction costs, although at the same time it offers its owner no associated perks. On the fancy side is an American Express card, which costs around 3.5% per transaction but is twinned with a raft of benefits including reward points, the right to dispute a transaction, and insurance coverage. Mastercard and Visa come somewhere between. As you can see, spending one sort of dollar is very different from spending another sort.

The free banking era and the "multitude of dollars" problem

There's a precedent for this sort of dollar heterogeneity. During the U.S.'s so-called "free banking era" that lasted from the 1830s until 1863, hundreds of different types of banknotes circulated, each issued by a unique bank. Notes were universally redeemable in a certain quantity of gold. Varying physical distances between a note's final resting point and its birth at an issuing bank (often in another state) led to widely disparate redemption costs across note brands. A merchant in Philadelphia who was paid in local bank notes need only take a short walk in order to redeem the note. If that same merchant was paid in a note issued by a bank in Chicago, however, redemption was much more onerous due to the time and distance required to travel from Philadelphia to Chicago.

So in the same way that an American Express dollar is the most costly of the modern day dollars, a distant bank's notes were the most costly of the free banking era's dollars.

Here are two interesting problems. How can a merchant establish a single set of sticker prices while still accommodating a wide range of disparate dollar payments media? Second, consider the fact that shoppers paying with a premium card like American Express (or distant bank notes) enjoy the widest range of benefits, but should also face the highest costs. How can the system ensure that the person who enjoys the marginal benefits associated with a given payments medium also bears its marginal cost? Put differently, how is quid pro quo ensured?

The solution: surcharging

In the free-banking era, the "multitude of dollars" problem was solved by a form of discriminatory surcharging. To begin with, merchants displayed their sticker prices in terms of a single unit; standard U.S. dollars (defined as 1.5 grams of gold). When the customer arrived at the till, the merchant determined what sort of surcharge to apply to each of the banknotes proffered according to its distance-to-redemption. With hundreds of note-issuing banks in existence, this was a cumbersome task. In order to speed up the process, the merchant would consult what was called a "bank note reporter." This handy publication, which was compiled by professional bank note analysts, provided merchants of a certain location, say Philadelphia, with the rates for all bank notes that circulated in Philadelphia adjusted for their shipping costs.

The image below is a section from Van Court's Bank Note Reporter and Counterfeit Detector, which I've snipped from Gary Gorton's introduction to the subject. It shows the the recommended price at which a merchant in Philadelphia should accept notes from Vermont, Maine, Pennsylvania, and elsewhere.

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

After a merchant had consulted his bank note reporter and tacked on the appropriate surcharge, it was time to redeem the note. Merchants didn't actually ship the notes themselves but sold them to a local note broker at a discount to face value. In fact, the numbers that Van Court published would have been sourced from this broker market. The broker in turn shipped the note back to the issuer, getting full face value upon redemption. The gap between face value and the initial purchase price covered the broker's shipping costs.

Thus the "multitude of dollars" problem was solved. By surcharging relative to a benchmark dollar, merchants succeeded in setting a single array of prices while accommodating a much wider range of heterogeneous payments media. This also allowed them to efficiently pass the marginal cost of using distant notes onto those customers who chose to pay with them, while rewarding customers who used low-cost local notes by not applying such surcharges.

So why not implement this same technique of surcharging today?

Consider that in our modern era, credit card networks recoup much of the cost of the services they provide (which are many, but include perks like rewards and the right to dispute a transaction) by requiring that card accepting retailers collect a fee from customers on the network's behalf. This parallels the free banking era, in which banks required third-parties to bear the cost of transporting notes for redemption.

The best way for a modern retailer to establish prices in this heterogeneous dollar world would be to replicate the solution settled upon by their free banking ancestors: set sticker prices in terms of the most basic unit, paper dollars, and exact an appropriately-sized surcharge on each card transaction at the till.

Rather than an old-fashioned Van Court's Recorder, a merchant could go about this by installing card-reading software that would quickly determine both the card being used and the appropriate surcharge. Thus, consumers who paid with premium cards, those cards that offer the most bundled services per transaction (and therefore incur the highest costs), would have to bear the largest surcharge while those with bare bones cards would pay a minimal surcharge. Anyone paying in cash, much like those who payed with local banknotes during the free banking era, would not incur any surcharge whatsoever. This system would ensure that each customer bears the marginal cost of their chosen means of payment. The retailer, who routes all of the surcharges they collect back to the card network, doesn't eat any costs and therefore succeeds in preserving their margins.

If only things were that easy. Though surcharging would be a great way to deal with the "multitude of dollars" problem, card networks like Visa and Mastercard have typically "legislated" against surcharges.* The networks can successfully impose this no-surcharge obligation on retailers because as an oligopoly, Visa and Mastercard can banish offenders from the network, putting a huge dent in the offender's sales. Why prevent surcharges? One reason the card networks probably do this is because they don't want the card-paying public to feel that they are being penalized in any way. If the feel put off, consumers might choose alternatives like cash and debit that aren't subject to surcharge.

Another solution: discounting

The no surcharge rule puts retailers in a bind. They are obligated to collect fees on behalf of the card networks, but without the ability to surcharge they're left absorbing the costs imposed by the networks while the customer enjoys all the benefits.

There's a neat way that that retailers can get around this hurdle. All they need to do is to mark up all their sticker prices to the level of the highest cost credit card, and then offer discounts to everyone who uses lower cost credit cards, debit cards, or cash. Discounting allows the merchant to collect the appropriate fee from each customer, funneling these fees back to the networks. As before, a given set of prices can accommodate a wide range of dollar payments media. Each party who enjoys a given marginal benefit also bears its respective marginal cost.

So as not to leave our analogy hanging, if this solution had been chosen by free-banking era retailers (perhaps because the free banks insisted that merchants avoid bank note surcharges), then the price level in Philadelphia would have been marked up to the value of the most-distant bank notes in circulation, say those from Chicago. Those paying in less-distant bank notes, say New Jersey notes, would have received an appropriately-sized discount.

An anomaly: we don't see discounts

Having outlined how to solve the modern "multitude of dollars" problem without surcharging, what happens in the real world? An odd phenomena tends to play out. While retailers have certainly marked up prices to a premium card standard (or thereabouts) in order to cover their costs, for some reason they rarely offer their customers discounts on cheaper payment options. Try asking for a cash discount at Walmart the next time you visit. This means that anyone who purchases something with cash, debit, or a bare bones credit card is being forced to pay for a juicy set of benefits associated with usage of an American Express card, namely fancy rewards and dispute rights, without actually getting to enjoy those benefits. Put differently, the merchant is effectively overcharging their customers by collecting more network fees than the networks actually require, keeping this excess to pad their bottom line.

Why this predatory behavior? Briglevics and Shy note that merchants may be wary of discounting if it creates confusion and distrust among customers. Potential delays at checkout counters might impose an extra set of costs on all parties. They also point out that merchants may not find it profitable to offer a cash discount to consumers who would use low-cost payments anyway. Schuh, Shy, Stavins, and Triest report that merchants may lack complete information on the full and exact merchant discount fees for their customers’ credit cards, and therefore can't implement a policy of accurate discounting.

Could it be that the right set of tools to provide discounts hasn't yet been created? Perhaps we need a modern version of Van Court's Bank Note reporter. Such a technology would allow merchants to rapidly determine the proper discount to apply to each disparate dollar type and clearly inform customers about the saving they have enjoyed.

Lack of technology may explain why cheap credit cards don't receive discounts relative to expensive ones, but it doesn't explain why cash discounts has never been adopted by retailers. One theory is that even if certain retailers start to offer discounts, the public may be too overloaded with information to switch, thus allowing the practice of predatory pricing to remain the status quo. Supporting this view is the following observation: while discounting for cash and debit payments is rare in most sectors of the economy, it is quite common among gas stations, as the image below shows.

Why so? Gas stations sell one homogeneous, universally available, repetitively-purchased good. Gas consumers are by-and-large brand insensitive, gas from one station being just as good as gas from another. Repetitive trips to buy one simple commodity probably makes it easier for lethargic consumers to make dispassionate price comparisons across competing gas stations. From the gas station owner's viewpoint, the consumers' price sensitivity only increases the efficacy of a policy of price discounts on cash and debit. After all, a gas station that offers users of low-cost credit cards a 0.5% discount or a cash discount of 1% should be able to win business away from station across the street that doesn't offer any discount whatsoever.

Other retailers, say department stores, sell a wider variety of things than gas stations, many of these items only being purchased from time to time. This makes comparison shopping more costly. Brand loyalty only increases the hassles of switching. Department stores may find that a policy of cash discounts is simply not worth the effort as discounts get lost in the morass of data that a consumer is bombarded with on an hourly basis.

That being said, the online world's ability to provide faster cross-retailer comparisons than are possible in a bricks & mortar world could shake things up. Surely some smart fintech entrepreneur can create a way for online merchants to rapidly measure the appropriate discount (or surcharge in those jurisdictions that allow it) to apply to each card before consummation. This same tool would provide a user-friendly format for online shoppers to "see" competing card discounts across a number of merchants prior to hitting the buy now button. Just like they'll cross the street to hit the cheapest gas station, they may divert their purchase to the lowest cost website. If this sort of thing caught on, we'd see long forgotten free banking customs replicated in our modern era.

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*This is currently the case in Canada. In Australia, merchants have been allowed to surcharge since the early 2000s. US merchants recently won the right to surcharge, although it is probably too early to know what effect these rule changes will have.

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)