In 2009, before it became home to 70% of the global transactions of the world's leading cryptocurrency, Mt. Gox was just a website for trading Magic: The Gathering cards. On Tuesday, visitors to the site encountered a blank page and a note that said a "decision was taken to close all transactions for the time being," citing "recent news reports and the potential repercussions on MtGox's operations."
The anodyne language belies the fact that Mt. Gox is now the black spell tugging at the center of a universe far larger and stranger than any wizard could conjure up. Hackers appeared to have wiped out 744,408 bitcoin—350 million dollars—that were being held by the exchange for its users. If true, that amounts to about 6% of total bitcoin, which would be the biggest cybertheft of any currency in history. The price of one bitcoin promptly sunk from the mid-$500s to below $400 for a moment on Tuesday before rebounding to about $550, a long cry from November's highs, when a bitcoin's value was briefly worth more than an ounce of gold.
The Mt. Gox CEO Mark Karpeles resigned from the board of the Bitcoin Foundation and called this a "turning point" for the cryptocurrency. Optimist / investor Marc Andressen dubbed it an "MF Global" moment, referring to the infamous derivatives firm that stole some $1.6 billion from its customers. Others have simply called it the beginning of the end of Bitcoin.
Chart of Bitcoin prices via Bitstamp
Bitcoin isn't dead, not yet. But what is it? You can't hold a Bitcoin, but things have gotten real. You can, for instance, go to the offices that contain the people and the computers that make Bitcoin work. For two weeks, protesters have lingered outside Mt. Gox's headquarters in Tokyo, holding their signs, demanding answers and bitcoins (one of them lost three hundred of them; a class action lawsuit is underway). Last week, citing "security concerns," Mt. Gox quietly relocated its office to elsewhere in the Shibuya neighborhood, and Karpeles, like a certain former Ukrainian president, hasn't been seen since. But the Bitcoin protesters aren't just angry depositors, reenacting the Wall Street panic of 1907 with Google glasses on. They speak for a whole movement that isn't going away, a movement that isn't just after money but, it insists, after change.
When Mt. Gox suspended withdrawals two weeks ago, Karpales told the Wall Street Journal, “We are very surprised that anyone could fault Mt. Gox instead of the bitcoin software." It's true that since 2011 Bitcoin’s developers have known about a software bug, one that creates a brief time period in which the unique ID of a transaction can be changed, but have done little to fix it. Mt. Gox is to blame too for the "transaction malleability bug," as it has been described in an alleged internal document that began circulating on Monday. It appears that its automated software for approving withdrawals wasn't very good at catching fraud.
The site has repeatedly been hacked, frequently suspended withdrawals, been sued by Bitcoin incubator CoinLab, and had about $5 million in assets seized when the U.S. government shut down two of its American bank accounts. There was also one big security bug on Mt. Gox early on—in the days when bitcoin's market cap was about zero and Mt. Gox was still run by Magic card entrepreneur Jed McCaleb. It's not clear if that was related to the hacking, but it was a bad omen. According to an early Mt. Gox user, passwords weren't just stored in plaintext, but displayed in the website's URL. It was a carnal sin of cyber hygiene, and another reminder that no matter how trustworthy is Bitcoin's math, the credibility of the humans involved leaves a lot to be desired.
The story of Mt. Gox's demise, as told in the leaked document, sounded familiar enough (well, mixed with a bit of Japanese scifi): a financial institution deeming itself too big to fail and strategizing a bailout, not just for itself but for the good of the whole economy. In the leaked document, those strategies appear to include a debt-for-equity swap, capital injections, and the use of something like preferred shares. Ironically, these maneuvers echo precisely the sort of over-leveraged, intertwined inert financial system that Bitcoin promises to deliver the world from. With Bitcoin, there are no governments taking money out of bank accounts to prop up an economy; there's no central bank to cause inflation; indeed, there's no regulation at all.
Or there's the start of regulation, at least in places like New York, a sign at least that bitcoin has reached a new level of credibility. Mt. Gox's demise "may be a significant bump in the road, but I don't think they're going away or it's any kind of death knell," Ben Lawsky, Bitcoin's would-be top regulator, told CNBC on Tuesday. He wouldn't issue any warnings against it, but the Alabama Securities Commission warned its citizens to avoid buying Bitcoin, in a move that's likely to be repeated elsewhere.
Meanwhile, authorities in Japan, where Mt. Gox is based, said they don't regulate Bitcoin-related companies; it's "not a currency; it works as an alternative to currencies, like gold,” a spokesman of Japan’s banking regulator told the Journal this week. Ultimately, though, Mt. Gox was a financial services company that was not being regulated the way financial services companies typically are, with FDIC protection and the like. "What keeps them honest is the amount of money they're making," one Mt. Gox user wrote on a bitcoin forum in 2012. Honest or no, regulation or not, the Journal also reported, federal prosecutors have subpoenaed Mt. Gox for certain documents along with a host of other bitcoin-related companies.
It is the aspiration for credibility—not to mention billions of investors' dollars at stake—that has left some Bitcoin insiders furious and the rest eager to move on, fast. For an increasing number in the increasingly slick world of Bitcoin, that means accepting that regulatory push as part of growing up.
Of course, for now, there would be no bailout. Rather than banding together to prop up the exchange, a group of other exchanges alongside the Bitcoin Foundation quickly distanced themselves from Mt. Gox. And as news broke about its insolvency, so too did reports about a new fortitude within the Bitcoin community, a resolution, as five venture capital-backed Bitcoin firms wrote in a joint statement, to establish “transparent, thoughtful, and comprehensive consumer protection measures.” This isn't just hollow language. With or without regulations, the people invested in Bitcoin and its businesses won't survive at a hundred million dollar business if that business can't be trusted.
That sense of trust can't come sooner. A new paper by researchers at Southern Methodist University and Carnegie Mellon found that among forty Bitcoin exchanges established over the past three years, "18 have since closed, with customer account balances often wiped out." Based on the math, an exchange’s transaction volume is a good indication of whether or not it is likely to close. Less popular exchanges are more likely to be shut than popular ones, but that popular exchanges are more likely to suffer a security breach.
Bitcoin exchanges, from "Beware the Middleman: Empirical Analysis of Bitcoin-Exchange Risk," by Tyler Moore and Nicolas Christin.
On Tuesday, SecondMarket, an online marketplace for selling illiquid assets like bankruptcy claims and private company stock, announced it was planning to launch a US-based Bitcoin exchange in New York, along with a trading desk, “digital currency asset management,” and a $20 million investment. Last week, the Winklevoss twins filed an application with government regulators to start a Bitcoin investment fund. And Coinkite, a Toronto-based “cryptobank,” recently rolled out an audit report feature that allows its customers to verify that the company is actually solvent.
"We have a big commitment to transparency," Coinkite’s founder and CEO, Rodolfo Novak, told my colleague Patrick McGuire yesterday. "Users’ funds are segregated and allocated to their own private key. We believe that all web wallets, exchanges and websites holding your funds should provide proof of reserves—users should demand it.”
“It's been known that Mt. Gox had issues for a long time now," he added, even though it was one of the largest bitcoin exchanges. "I'm glad this chapter is finally over and professional companies can take cryptocurrencies forward."
But is that going to be enough to inspire trust? The Mt. Gox episode doesn't just bear echoes of the bank failures of 2008; in many ways, it more closely parallels the Ponzi and other schemes of people like Bernard Madoff and companies like, indeed, MF Global. There's no evidence yet that Mt. Gox or Karpeles were running a Ponzi scheme or the like, although the authorities in New York might decide that. But since 2008, under decades-old regulatory strictures, some $50 billion has been lost in various dollar-denominated investment schemes in the U.S. (Under a settlement, some 93% of MF Global funds will be returned to customers, while only $2.35 billion of the $50 billion that Madoff lost has been paid back.)
In these cases, the points of weakness, as Madoff knew well, are human trust and the ability to falsify records. The same goes for Bitcoin—sort of. In theory, falsifying records with Bitcoin is a lot more difficult. The transactions that occur on the blockchain are public and transparent; while bitcoin was once touted as an anonymous currency, some now like to call it pseudonymous. Either way, it's not untraceable. And as it's designed, decentralized and distributed, the code that underlies bitcoin is seemingly transparent and—notwithstanding the error that did in Mt. Gox—impervious to sabotage. After decades of stalled efforts at digital currencies, Satoshi Nakamoto had a breakthrough, establishing a cryptographic proof that someone had mined, possessed, or spent a bitcoin. This is mathematical trust, with no human, institution, or government to adjudicate (and to exact fees in the process).
At least, it works most of the time. The Mt. Gox saga is a reminder that some kinks still need to be worked out. As for the mining lottery—the system that produces bitcoins—it requires such heavy computing power that it would be very difficult for any single miner or even mining pool to control the 51 percent of the process required to damage the system. After concerns emerged in January that a mining pool named Ghash has gained more than 40 percent of the computing power on the network, Gnash issued a press release claiming the group had no ambitions to do anything harmful. And if they tried, they would potentially be working against everyone else using bitcoin. Any miner that seems untrustworthy can theoretically be ignored by the rest of the system—though that depends on the community recognizing a bad actor before it's too late.
"Bitcoin is supposed to be a currency and a protocol where I don't have to trust anyone," Vili Lehdonvirta, an economic sociologist at the Oxford Internet Institute, told New Scientist last month. "But now suddenly I'm in a situation where I have to trust a large mining-pool operator who says, 'Don't worry, we're not going to do anything bad'."
To quote an internet commenter recently in praise of Bitcoin: "I trust math not humans." The math of bitcoin however can only do so much: where will Bitcoiners summon the rest of the trust needed to keep the currency going? The blockchain is secure, in theory, but it still relies on humans to keep it humming along. Other humans meanwhile operate the system of exchanges and services that have become the plugins for Bitcoin, like Mt. Gox.
That points to the more psychological side of Bitcoin—and indeed any asset—the one involving people who are buying and selling it, spending it on socks or on drugs, keeping it in their wallets or letting others take care of it for them. Other software-based systems are emerging to further protect the bitcoin from fraud and loss. But the fact remains that if the value of bitcoin dropped to zero tomorrow—and this isn't completely out of the question—there's nothing anyone could do to stop it.
A protestor confronts Mt. Gox CEO Mark Karpeles (Photo: screencapture of video by Jon Southurst)
The story of Mt. Gox's demise sounded familiar enough: a financial institution deeming itself too big to fail and strategizing a bailout, not just for itself but for the good of the whole economy.
The only way to keep it going is to have faith in bitcoin and trust in the institutions that keep it working. That faith and trust won't be about math, not just. That would be foolish: imagine a pilot flying only by his or her instruments without looking out the window at what's ahead—or a spy agency letting its technological capabilities exceed what's lawful. If Bitcoin is to remain true to its anti-establishment, decentralized premise, that faith and trust won't involve the Federal Government either. Bitcoin may be a great currency for donations and tips, but there won't be any bailouts.
Instead, Bitcoin will continue to rely on a mix of some of the most sophisticated cryptography—in order to keep it functioning—as well as on a very human faith in the possibilities that the cryptogrphy allows, from decentralized banking to more efficient ways to pay, tip and donate money.
That faith is being tested hard now. The value of a Bitcoin is less than half its peak last year and still in much flux; an untold number of Bitcoin users may have lost their cash for good or simply can't access their funds; and the entire system of Bitcoin may be compromised. But hope springs eternal in Bitcoinland. Based on that alleged internal document (which no one has been able to verify) and an internet domain registration, even Mt. Gox appears to intend to rise again as "Gox," with a new CEO and new software.
There are some hopeful theories about Mt. Gox's demise. Could it's sudden closure conceal a larger, unknown plan to buy and reform the company and make it solvent again? Could China, where 30,000 Bitcoins have changed hands since Tuesday, quadruple the normal trading volume, boost the economy again? In a note on Tuesday, Bitinstant CEO Charlie Shrem, who stepped down from the Bitcoin Foundation last month amidst money laundering charges, said that he had spoken at length to Mark Karpeles "and the team" over the weekend, and "I see good news on the horizon for people who have funds stuck in MtGox (I also have funds in MtGox stuck)."
No matter what, as in politics and as in games (Bitcoin relates to both), all the hope about the future of this alternative currency also comes with an unknown risk. That was the lesson that the libertarian Bitcoin evangelist Erik Vorhees urged in a note on Reddit on Tuesday night:
… the lesson is not that we ought to seek out "regulation" to save us from the evils and incompetence of man. For the regulators are men too, and wield the very same evil and incompetence, only enshrined in an authority from which it can wreck amplified and far more insidious destruction. Let us not retreat from our rising platform only to cower back underneath the deranged machinations of Leviathan.
The proper lesson, if I may suggest, is this: We are building a new financial order, and those of us building it, investing in it, and growing it, will pay the price of bringing it to the world. This is the harsh truth. We are building the channels, the bridges, and the towers of tomorrow's finance, and we put ourselves at risk in doing so.
Bitcoin's dream of digital cash—Tyler Winklevoss calls it "cash with wings"—may seem rooted in the Valley's technoutopia, but maybe it's as old as money and art: the belief that technology can make the world better, and that certain objects—wampum, Magic cards, Facebook stock, cryptocurrency, whatever—are worth having because they'll be valuable tomorrow and the next day and hopefully the next, until you decide to use them. And somewhere along the way, Bitcoiners might find themselves in an interesting conundrum, putting trust in a kind of middleman, while repeating one of the movement's old tenets: never put blind faith in your financial institutions.