In the aftermath of the demise of bitcoin bank Mt. Gox comes a few startling revelations. A newly released “Crisis Strategy Draft” confirms some unfortunate truths long suspected of its handling of clients’ bitcoin deposits. (The document might be a fake, but I’ll accept it as legitimate until proof surfaces otherwise.)
The first unfortunate truth is Mt. Gox’s admission that it is a fractional-reserve bank. Seeing this problem for what it is, the company is now looking to enter into agreements with its partners to “erase a significant portion of [its] debt.”
I previously relied on the ample literature of how fractional-reserve free banks are supposed to work in order to illustrate why it was clear Mt. Gox was a fractional-reserve bitcoin bank (here, here and here). Here we have another case where free banking theory is, unfortunately, demonstrated to be true in practice. The free banking literature says that any liquidity problem faced by a member bank can be solved by asking for lines of credit and concessions from other banks. As long as the illiquid bank is fundamentally solvent there should be some deal struck to extend it credit to get it through its time of trouble until it regains its footing. Mt. Gox is seeking the help of other “Bitcoin main players” to assist it in injecting new bitcoins onto its books.
This strategy of seeking the assistance of other banks may seem positive in that it extends the life of an otherwise troubled bank. There is ample evidence to demonstrate that it is exactly these types of agreements to support each other that ultimately develop into larger centralizing arrangements. In a similar application, Philipp Bagus and I have documented how the Federal Reserve System emerged from a series of small arrangements between private fractional-reserve banks during the Free Banking Era that culminated into an agreement to centralize reserves and coordinating policy amongst the individual banks, first at the hands of the clearinghouse system, and later more formally through the creation of the Fed (available here as a pdf).
This bodes poorly for a bitcoin community which prides itself on the fact that it does not need government oversight or aid in solving its problems. There is a more troubling revelation in the Mt. Gox crisis strategy document however.
On its current balance sheet the company lists its assets as consisting of 2,000 bitcoins (plus $32 mn. in fiat), and offsetting liabilities of 750,000 bitcoins (and another $55 mn of fiat claims against it). There is a clearly a big hole to fill. More troubling is that Mt. Gox notes that this theft of its bitcoins took place over a five-year period. Furthermore the company now confirms that the loss is due to the “transaction malleability” issue with the bitcoin protocol (which I discussed here as a reason Mt. Gox held only fractional reserves).