DEFINITION of Kimchi Premium

The kimchi premium is the gap in cryptocurrency prices in South Korean exchanges compared to foreign exchanges. The kimchi premium is predominately seen in the price of bitcoin.

BREAKING DOWN Kimchi Premium

Currency traders look for mismatches in exchange rates when identifying arbitrage opportunities. Currency arbitrage involves placing trades based off of differences in the quotes for a specific currency pair offered by different brokers, rather than placing trades based on the exchange rate movement of the currency pair. A trader will buy and sell two or more currencies simultaneously, making the trade risk-free since there is no open currency exposure.

Arbitrage opportunities are often short-lived, as investors (or their trading algorithms) identify the pricing mismatch and place enough trades so as to make the arbitrage no longer profitable. This currency trading strategy has not worked in South Korea when it comes to virtual currencies.

South Korea has long been one of the larger markets for cryptocurrencies, accounting for roughly 10% of bitcoin trading. Economists believe that interest may be driven by a lack of other high-return investment options, though the country’s interest in technology as well as gambling are also speculated to be factors.

Whatever the ultimately reason for the demand, South Koreans pay a higher price for bitcoins than traders in other countries. This has been dubbed the "kimchi premium," in reference to the fermented cabbage that is a staple in Korean cuisine. This price difference was starkly evident in December 2017, when the price of bitcoin in South Korea was more than 40% higher than prices in the United States.

In order to take advantage of arbitrage, South Korean traders would first have to exchange the Korean won for a different currency, such as the U.S. dollar, to purchase a bitcoin on a foreign cryptocurrency exchange. Foreign investors would simply have to purchase bitcoins abroad and sell them on a South Korean exchange. The draw of profit should have eliminated this gap arbitrage, but capital controls, financial regulations, and anti-money laundering laws make the process difficult.

South Koreans and South Korean firms are limited to the amount of money they can move out of the country each year, and the transfer must be approved by regulators. Regulators are likely to block the transfer for fear that it is really being made to launder money.

Even if regulators approved of the transfer, it may take so much time that the arbitrage opportunity is no longer available. Capital controls also limit the inflow of cryptocurrencies by foreign investors. This has created a scenario in which digital currencies can only be traded in South Koreans by South Koreans.

The South Korean government has proposed a ban on cryptocurrency trading. According to the cryptocurrency website CryptoCompare, more than 10% of ethereum and 5% of bitcoins are traded against the South Korean won. This outsized impact of South Korean regulation, as well as the threats of a ban in China, may have been a leading cause in the sell-off of bitcoins in January 2018.

The South Korean government also indicated that it may consider alternatives to a complete ban, such as having investors pay capital gains taxes. It may also require investors to register investment accounts in their own names to combat money laundering. (See also: Why Is South Korea So Important to Bitcoin Prices?)