MtGox Bitcoin Bankruptcy Illustrates Counterparty Risk

By Jason Van Steenwyk

Bitcoin bulls took an uppercut in the chin this week when the premier bitcoin exchange, MtGox, announced it couldn’t account for 744,000 bitcoins. At today’s typical exchange rate of $572 per bitcoin, that amounts to a heist of more than $425 million. To put it in perspective, someone has apparently stolen about six percent of the world’s supply of bitcoin.

Salut, Don Corleone!

In response, one of the prominent opinion-makers on bitcoin – and one of its early Kool-Aid drinkers, Ryan Galt, quickly circled the wagons and sold off all his bitcoin holdings in preparation for the market reckoning that was sure to come.

“This is catastrophic, and I am sorry to share this,” he wrote, “I do believe that this is one of the existential threats to bitcoin that many have feared and have personally sold all of my bitcoin holdings through Coinbase.”

The market blowback didn’t, however, materialize. At least, not yet.

Bitcoin has been declining for months, but the MtGox shutdown is not yet lethal for the currency.

Bitcoin has been declining for months, but the MtGox shutdown is not yet lethal for the currency.

As this chart clearly shows, bitcoin has been declining steadily against the dollar for months – and this week’s revelation from MtGox didn’t make much of a dent.

Yes, there was a huge surge in volume on the 25th, as the news of the MtGox breach went public. But the selling pressure was met with demand, and bitcoin prices actually rebounded from their low just below $500 back to a “typical” price of $572 at press time.

The chart seems to indicate that there is still substantial latent demand for bitcoin, despite the MtGox announcement. At least for now.

Meanwhile, other bitcoin companies, including Blockchain, Coinbase, BTC China, BitStamp, Kraken and Circle are circling the wagons, publicly distancing themselves from MtGox’s woes, which they are portraying as unique to that particular company.

But the fallout from the heist presents a longer-term threat to the very thing that made bitcoin attractive to many of its most enthusiastic supporters and users: Freedom from government interference.

“Big Boy” Rules In Effect

Because bitcoin is frequently referred to as an ‘online currency,’ many bitcoin owners may well have believed that they were putting their money into a bank. Today’s investors have been spoiled by generations of robust regulatory oversight ensuring the basic solvency of banks and security broker/dealers. They are also quite accustomed to the safety net afforded by such programs as the Federal Deposit Insurance Corporation (FDIC) and the Securities Investor Protection Corporation (SIPC), both of which have protected thousands of consumers in the U.S. by making good on bank deposits where banks have failed, or by replacing securities that may have been stolen via fraud within a broker/dealer.

Neither regulatory protection nor insurance protection, however, is available to MtGox customers, who are now unable to withdraw bitcoin stored on MtGox’s servers, nor are they able to access cash. And so, having been attracted to bitcoin in the first place in part because of the freedom from government regulation central bank interference, MtGox customers are now turning to the same governments they disdained in buying bit coins for relief.

In the short run, they haven’t been getting much traction. MtGox is physically located in Japan, but no Japanese government agency has thus far stepped forward to claim oversight.

In the longer run, however, bitcoin bears fear that the ship has struck an iceberg and is flooding below the waterline. The damage may be invisible on the surface, but give it time and the damage could be catastrophic. How? Because it gives governments who are threatened by the bitcoin experiment an excuse to intervene.

“The MtGox scandal shows that the bitcoin community has completely lost its self-righteous claim to self-policing,” Galt argues. “The event is too big and too deep, and that will mean tougher regulations.”

Bloomberg columnist Megan McArdle is also sounding the alarm bell about vastly increased regulatory risk for bitcoin holders.

“I’ve never been very bullish on Bitcoin, because ultimately, the better it performs at evading government surveillance of currency transactions (and government ability to manage debt loads via inflation), the harder those governments are going to try to shut it down,” McArdle writes. And it turns out that governments are very good at shutting down these sorts of … call them financial workarounds … because they can order the banks and payment networks that service the vast regular economy to refuse to take Bitcoins or take payments from companies that do take Bitcoins. What governments have done to online poker and offshore banking havens, they can do to Bitcoin vendors.

McArdle conludes: “What happened at MtGox only helps the government make its case for much tighter regulation of these networks. Which means that after yesterday’s news, I am less bullish still.”

At least one prominent U.S. politician, Senator Joe Manchin of West Virginia, has written to regulators including Federal Reserve Chair Janet Yellen and Treasury Secretary Jack Lew calling on them to “take appropriate action to limit the abilities of this highly unstable currency.” His concerns:

  • Criminal elements have used bitcoin and the anonymity it provides to traffic in drugs and illegal firearms
  • Fraudulent transactions are almost impossible to reverse.
  • Other countries and banking systems, including China and Thailand, have placed outright bans on bitcoin.
  • South Korea will not recognize the currency.
  • As other countries ban the currency, it will be Americans left “holding the bag on a valueless currency. “

Not everyone is dismayed at the fall of MtGox, however – and some are cheering a possible migration of the bitcoin center of gravity to more tightly-regulated exchanges in the U.S.

“There have been red flags around MtGox for some time, which in part led to it losing its role as the dominant Bitcoin exchange,” Jeremy Lew of Light speed Venture Partners told a reporter for the Los Angeles Times. “Hopefully now there will be an opportunity for a U.S. based regulatory compliant exchange to build meaningful liquidity.”

Kadhim Shubber writes in Slate that the MtGox collapse offers “a glimmer of hope that bitcoin’s reckless youth may be behind it.”

Who’s right about bitcoin’s future? Who knows? The lesson to carry forward from here is this: Beware counterparty risk.

In a regulated economy like the U.S.’s, we have certain backstops, and everyone pretty much knows what they are – such as FDIC and SIPC, for example. We also have two imperfect watchdogs over both securities and the exchanges and broker/dealers that facilitate their transactions in FINRA and the Securities and Exchange Commission.

But once you leave your neighborhood bank, you must never lose sight of the fact that “big boy “rules are in effect.

Consider: MtGox isn’t named for a mountain. It’s actually derived from the phrase Magic: The Gathering Online eXchange. And the business was never actually originally designed to handle huge currency exchanges. It started as a place for kids to trade playing cards for a popular game.

Now, this isn’t a deal killer. Berkshire Hathaway used to be a struggling textile business in New Bedford, Massachusetts before Warren Buffett took the name and applied it to his own conglomerate holding company.  Incidentally, Buffett later said that buying the textile company was the biggest investment screw-up he ever made.

Now, Warren Buffett is perfectly capable of losing your money. But over the decades, there is no doubt that he has a track record as an impeccably skilled investor who can function at the very highest levels of finance.

There was nothing in MtGox CEO Mark Karpeles’s background that indicates that he’s the guy to oversee 70 percent of the worlds’ supply of bitcoin.

This wasn’t even MtGox first serious security problem. They had a big one in June of 2011, when a hacker penetrated the firm’s systems, created a huge “ask” order and drove bitcoin prices down to a penny.

Vulnerability in their database also caused their list of customers/accountholders emails, usernames and hashed passwords to be compromised and eventually released on the Internet.

Finally, MtGox customers had already been having troubles withdrawing balances – sometimes having to wait months for their money.

 

 

 

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