Bitcoin Bank Run

220px-Bitcoin-coins-150x150Ever wonder what a digital bank run looks like? Nearly one million Mt. Gox users are finding out first hand.

The Tokyo-based exchange, popular amongst currency traders, has risen in prominence by offering its customers storage services in a variety of currencies. This effectively makes it act as an online bank. One such “currency” that it allows accounts to be denominated in is bitcoin.

Yesterday the exchange halted withdrawals of the digital currency, citing a technical malfunction. It promises to reopen for business on February 10th. What many news sources are missing is that this is not a particularly new development – the exchange has been rejecting customer withdrawals on-and-off for about two months.

What may be happening is a good old fashioned bank run. Like all banks, Mt. Gox is operating under a system of fractional reserves, loaning out or otherwise making use of bitcoin deposits entrusted to it. There are many more claims to the bitcoins depositors have with it than are actually in the digital “vault” at Mt. Gox. This is not unlike your bank, which has many more claims to each dollar deposited in it than it has dollars in the vault to honor. If too many people make a withdrawal at the same time, your bank has two options.

Option one is that everyone gets some small percentage of their original deposit. Option two is that only the first small percentage of people who get to the bank first get their whole deposit. Neither option looks very appetizing.

Mt. Gox has decided to use a method to stymie its own bank run which is not without precedent – it has halted redemptions. Of course, this policy was used widely by banks in many fractional-reserve regimes before the advent of deposit insurance, notably in Scotland.

In the Scottish fractional-reserve free banking experience, the option clause stated that a bank could halt redemption of a depositor’s funds, but would have to pay interest for this privilege. Besides the obvious rights violation of turning your deposit into a loan (but hey, at least they paid interest on it), the policy was also not able to stop banks from loaning out deposits until there was nearly a continual suspension of withdrawals. (At least, according to the expert on the period, Sydney Checkland.)

Mt. Gox has used this policy with a twist. Instead of promising your money back in the future with an added interest payment, it is “allowing” you to withdraw your bitcoin now by paying an additional fee.

Lest this post be misunderstood, this is not a fundamental problem of bitcoin, but one of fractional-reserve banking. Here we have an example of a purely unregulated currency succumbing to the same problems that have plagued money users for hundreds of years. When banks are allowed to function with fractional reserves, it matters not if the money is state-issued (like dollars) or market-created (like bitcoin), the outcome is the same: bank runs and depositors left with the inevitable losses.

(Originally posted at Mises Canada.)

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