Jeff Deist explains some of the compliance burdens of the IRS’s latest guidelines for cryptocurrency and other electronic media of exchange.
Jeff Deist explains some of the compliance burdens of the IRS’s latest guidelines for cryptocurrency and other electronic media of exchange.
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).
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.
We ventured down to the store, Azteco, yesterday to see what it was all about. What does a Bitcoin shop look like? Well, picture a large room, white walls and one desk – with a man hunched over a laptop – that’s it.
You walk in, pay some money and founder Akin Fernandez prints out a voucher with your Bitcoin code. “I wanted to set up the store to demonstrate this new easy way of buying Bitcoin,” Fernandez told The Capitalist.
Enough people were upset with my previous post claiming that Mt. Gox is suffering a bitcoin bank run because it is holding only a fractional bitcoin reserve that it caused me to think twice about the claim.
I could have been wrong, but I doubt it.
Actually, the backlash was strong enough that it made me think that perhaps I was using some common terms in strange ways. I referred to Mt. Gox as a bank, which is a stretch by some definitions, but it definitely stores bitcoin for clients and as such, acts as a custodian.
Maybe it was the term “bank run” that drew ire. Well, I’m pretty sure I know what a bank run is, but I turned to trusty Wikipedia just to be sure.
A bank run (also known as a run on the bank) occurs in a fractional reserve banking system when a large number of customers withdraw their deposits from a financial institution at the same time and either demand cash or transfer those funds into government bonds, precious metals or stones, or a safer institution because they believe that the financial institution is, or might become, insolvent.
Maybe I should have called it “a run on a bank”, but it´s six one way, a half dozen the other. Both terms describe exactly what I meant.
It could have been that what I was calling “fractional reserves” was somehow misplaced. (As I’ve written extensively on fractional-reserve banking, my potential misuse of the term troubled me greatly.) Again, turning to trusty Wikipedia:
Phew, so far so good. That’s exactly what I meant by the term.
So to summarize my claim, I have accused Mt. Gox of holding an insufficient amount of bitcoin in its “vault” to back all the claims to the cryptocurrency that its clients have.
I made this claim based on several basic pieces of economic theory. All of them involved ways that fractional-reserve banks operated back in a time before deposit insurance. Since there is no deposit insurance on bitcoin, Mt. Gox should be operating in a similar way to these banks, but only if it only has fractional reserves.
1. When fractional-reserve banks are faced with more withdrawal requests than they have money in reserve, they must halt withdrawals or face insolvency. This is what happens when a bank chooses to close its doors and not allow you to redeem your deposit. Mt. Gox has halted its redemption requests on-and-off for many months now, and as of February 7 has halted them indefinitely.
Ever 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.)
Paul Singer is the manager of the $23 billion Elliott Management hedge fund. In a recent letter to investors in the fund, he expressed bearish sentiments on bitcoin, while remaining bullish on gold despite its recent fall in price. Wrote Singer:
There is no more reason to believe that bitcoin will stand the test of time than that governments will protect the value of government-created money, although bitcoin is newer and we always look at babies with hope. If you want an alternative currency, check out gold. It has stood the test of thousands of years as a store of value and medium of exchange. Better yet, it is not just a computer entry in the ether somewhere, and it is currently available at a good price. Bitcoin and its relatives represent an understandable impulse (anti-big-government, pro-freedom, pro-modernity), but we do not see how it actually survives. . . . We think that gold is a unique investment asset, the only real money that has stood the test of time throughout recorded history. With its durability, finite and difficult-to-extract supply and natural allure, it is a store of value that should be particularly attractive at a time when monetary debasement is the major policy practiced by most developed countries to keep their economies afloat.
Whether or not Bitcoin survives and whether gold returns to favor among investors and, eventually, to its traditional monetary role are, of course, purely empirical questions, which cannot be solved by theoretical arguments. At the moment both are valuable commodities and neither one can be considered as money. Thus, tedious arguments on the blogosphere which invoke Ludwig von Mises’s regression theorem, are completely irrelevant to the issue. Both items are scarce commodities which are valued by consumers and command a price on the market. As such, the regression theorem does not prevent bitcoin from being monetized or gold from being re-monetized in the event or anticipation of a fiat-money breakdown. Rather, it is a matter of human valuations and volition which are not determined by economic law. In this matter, our only guides are historical experience and what Mises called “thymological” insight into people’s likely choices under varying circumstances. Will the general public trust and routinely accept a commodity embodied in lines of computer code or a tangible commodity that has served for millennia as the general medium of exchange? Hmmm, I wonder.
Overstock.com’s CEO Patrick Byrne explains some reasons why Overstock now accepts Bitcoins:
Fortune: Do you own any bitcoins?
Patrick Byrne: No. I own gold.
Really, how much gold?
A lot. Let’s just say enough that if zombies walked the Earth I will have enough gold that me and mine are taken care of.
But you’re obviously a bitcoin fan. Why?
There are business and philosophical reasons. First, the business reason: I think there are a legitimate number of consumers who want to be able to shop with bitcoin. They like the anonymity of the currency. So far, the market has only served them with shady websites, like Silk Road. Also, it saves us about 2% from interchange fees. It’s no secret that our net margin is about 2% now. And so the savings would be a very substantial improvement to our bottom line.
As far as the philosophical reason: I am from the Austrian School of Economics, which means we’re the guys who hate fiat money. The long-run value of all fiat money is zero. If you believe in limited government, you want to have a monetary system that is based on something where no government mandarin can just create money with a stroke of a pen. Gold is a solution, we’re not going to bring back the gold standard any time soon. We’re not going to get rid of the Federal Reserve any time soon, so bitcoin is a step in the right direction.
Peter G. Klein answers a viewer’s question, and discusses a critical battle between technology and ideology. Klein is the Mises Institute’s Executive Director and Carl Menger Research Fellow
It is important for our system of payments to improve over time and this means that we need experiments like Bitcoin to take place. Ron Paul says that if Bitcoin is successful then the government will crush it. Now there is a problem.
William Anderson Walter Block Per Bylund John Cochran Jeff Deist Thomas DiLorenzo Gary Galles David Gordon Jeffrey Herbener Robert Higgs Randall Holcombe David Howden Jörg Guido Hülsmann Peter Klein Hunter Lewis Matt McCaffrey Ryan McMaken Thorsten Polleit Joseph Salerno Timothy Terrell Mark Thornton Hunt Tooley Christopher Westley