A currency is only as safe as the bank that stores it. Nowhere is this more apparent than in the recent turmoil in the bitcoin community.
One the primary advantages of bitcoin, perhaps even the greatest advantage of the cryptocurrency, is the ability to do away with traditional banking institutions. By providing an option to transfer payments peer-to-peer at low cost and with great ease, bitcoins allow the currency user full autonomy in not only how he uses his cash, but also how others use it along the payments system. Indeed, the initial marvel of the bitcoin protocol from a purely technological point-of-view was the solution to the double-spending problem when making payments using a peer-to-peer system.
On 7 February of this year, Mt. Gox – a bitcoin exchange which essentially functioned as a depository (i.e., bank) for bitcoins – halted all withdrawals in the crypotcurrency. At the time I wrote two articles making a pretty clear case for Mt. Gox operating like a run-of-the-mill fractional-reserve bank (here and here).
Fractional-reserve banks that existed before the advent of deposit insurance were constrained by some real pressures as they decreased their reserves. As depositors became less sure that they would be able to access their deposits on demand, they would start demanding the fractional-reserve bank’s services at a discount to its competitors. As depositors started withdrawing their funds and endangered the liquidity and eventual solvency of the bank, the bank would react by either halting withdrawals outright (as Mt. Gox did on February 7), or temporarily delaying them while remunerating the client with an interest payment (i.e., enact a “option clause”, something Mt. Gox effectively did by charging clients an extra fee if they wanted their withdrawals expedited.)
The claim that Mt. Gox was operating with fractional reserves came as shocking to some. After all, the exchange functioned by providing a shared wallet for depositors. Each time a deposit was made in bitcoin, the proceeds were moved to the shared wallet. This wallet was safely stored offline (“cold storage”) so that hackers could not gain access to them. In addition, a very high percentage of bitcoin was supposedly stored in this way – up to 98% by some claims – with only a small amount held online to facilitate withdrawals and other transactions.
In theory, since almost all of the bitcoin were held safely offline by Mt. Gox, the “bitcoin bank” should have been behaving like any standard full-reserve bank. The evidence over the past months proved this to be anything but the reality of the situation.
On 28 February Mt. Gox filed for bankruptcy, with its liabilities amounting to about 2.65 trillion Japanese Yen ($25 billion) more than its assets. Also unaccounted for were about 750,000 of its customers’ bitcoins and 100,000 of its own bitcoins. This amounted to 7% of the total bitcoins in existence at the time, with a dollar value of nearly $500 million.