Mt. Gox’s Shutdown -- The Critical Questions for Bitcoin Investors

Mt. Gox, the largest Bitcoin exchange in the world, recently imploded. Prices at the Tokyo-based exchange plunged to under $100 before going offline on Feb. 25. The shutdown shattered the confidence of Bitcoin backers worldwide and raised serious questions regarding the future of virtual currencies.

Inconsistent prices across exchanges

Mt. Gox's implosion highlights a major problem with Bitcoin and other virtual currencies -- the lack of price consistency and opaque trading volume across its exchanges.

For example, when the value of Bitcoin plunged to less than $100 on Mt. Gox, many people thought that the value of Bitcoin had collapsed across the world. When Mt. Gox subsequently went dark, some people thought it meant that Bitcoin had become worthless.

Yet Bitcoin continued to trade at over $500 on the other major exchanges, such as Coinbase, Kraken, BitStamp, Circle, and BTC China. On these exchanges, the prices vary slightly. As of 11 p.m. EST on Feb. 25, Bitcoin was trading for $569.87 at Coinbase, $572.98 at Kraken, and $557.65 at BitStamp.

(Source: Businessofbitcoin.com)

The problem is that people often confuse Bitcoin and other virtual currencies with regular Forex trading. However, people can always trade dollars, yen, or euros because their value is maintained by a sprawling interbank system, rather than the supply and demand on a single exchange. For example, if a single bank runs out of dollars to sell, that doesn't mean the value of the dollar at the bank suddenly plunges to zero.

A hack plus a bank run
The reason that Bitcoin plunged on Mt. Gox was similar to a bank run -- there simply weren't enough Bitcoins in circulation to allow everyone to cash out at the same time. Bank runs usually occur when a bank invests too much of its clients' money elsewhere, leaving so little cash on hand that it can't survive a mass withdrawal.

Mt. Gox's possible insolvency, on the other hand, was rumored to be caused by a hack that resulted in the loss of 744,000 Bitcoins ($409.2 million). This isn't the first time it happened, either -- Mt. Gox was possibly hacked in 2011 for 400,000 Bitcoins (now worth $220 million). Mt. Gox customers have also reported troubles since early February, when CoinDesk reported that 68% of its customers had been waiting for months to withdraw their funds.

Therefore, even though exchanges like Mt. Gox might not be making risky bets with their clients' cash, their doors can be pried open by legions of hackers on the Internet instead. In the case of a bank failure or data breach, a depositor is insured by the FDIC for $250,000. In Bitcoin accounts, no such insurance policy exists.

Something for nothing
To understand why Mt. Gox was only the tip of a massive iceberg, we need to delve into the Bitcoin culture and compare it to a few perspectives on global currency.

In the past, paper currencies were pegged to precious metals such as silver and gold. This was done because there were always finite amounts of the metals. Nowadays, many countries, including the United States, have moved on to fiat currencies -- cash not pegged to any finite resource, but rather to the backing of the government. The supply and demand between banks sets the foreign exchange rate.

Bitcoin is seen by many as a movement against fiat currencies and a digital return to the silver and gold standards of the past.

Bitcoins are "mined" from a dense algorithm that can be processed on any computer. However, the amount of processing power and time that it takes to mine a single Bitcoin on a single computer should never be cost-effective considering the electricity consumed for the process. This is intended to set a "real value" for Bitcoin.

Yet to get around this, Bitcoin miners often join like-minded individuals and pool their processing power together, buy mining hardware to boost their processing power, or do both.

USB Bitcoin miners. (Source: Cryptocoinsnews.com)

Therefore, even though the Bitcoin algorithm was intended to never make it cost-effective to mine for Bitcoins, people are constantly trying to circumvent that limitation and get something for nothing. That kind of thinking, undoubtedly, was what led to the hack that caused Mt. Gox to crumble.

Meanwhile, Moore's Law -- which expects the number of transistors on integrated circuits to double every two years -- means that cheaper, faster chips in PCs could eventually deflate the value of Bitcoin and other virtual currencies over time.

In other words, miners will be able to extract more Bitcoins with better tech, but that will result in a surplus of Bitcoins -- which will in turn render exchanges obsolete and flatten out their market value.

Damage control and the road ahead
Looking forward, five leading Bitcoin exchanges (Coinbase, Kraken, BitStamp, Circle, and BTC China) issued a joint statement on Feb. 24 regarding Mt. Gox's "tragic violation of the trust of users."

In the statement, the exchanges promised to never "use customer assets for proprietary trading or margin loans in leveraged trading" and to ensure that the "appropriate security safeguards" are "independently audited and tested on a regular basis."

The price of Bitcoin on other major exchanges has since stabilized, and is still up more than 1,800% over the past 12 months.

(Source: Coinbase)

This indicates that the currency still has plenty of backers, despite Mt. Gox's meltdown. However, virtual currencies like Bitcoin -- such as Dogecoin, Litecoin, Coinye -- will likely be subject to stricter regulations in the future.

The bottom line
If you're thinking of buying Bitcoins, consider the key points -- it's not the same as Forex trading, there's no insurance policy if an exchange fails, and rising processing power in PCs could eventually result in a surplus and flatten out prices.

What do you think, dear readers? Is Mt. Gox the Bear Stearns of virtual currency, or is it merely an isolated incident that will encourage the remaining exchanges to tighten up their security? Let me know your thoughts in the comments section below!

This stock could be a better bet than Bitcoin
There's a huge difference between a volatile investment like Bitcoin and one that can make you rich. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.


Read/Post Comments (5) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 27, 2014, at 5:36 PM, twistcraft wrote:

    I'm amazed by how much Leo does not understand how bitcoin works! One would think that you should read an article or two on the subject before writing one.

    Moore's Law has absolutely no power here, because due to a proportional difficulty increase defined by the algorithm, it can only become harder to mine bitcoins as the total hashing power of the network increases and the corresponding number of produced bitcoins decreases. There is no possibility of surplus that you are considering, as less and less is produced while the total number remains capped. Leo seems to suggest that hyperinflation will kick in under the decreasing supply constraint which is a joke.

    I encourage you to understand the things that you are writing about to avoid looking too foolish!

  • Report this Comment On February 27, 2014, at 5:38 PM, user5701 wrote:

    Without government backing, virtual currencies become something around the same caliber as a non-backed security, ie, a stock investment. At least with stocks there is a company's products/services that make it worthwhile. Didn't people learn their lesson from Madoff?

    With virtual currencies, it's based upon processing power? Are we running SETI-Coin here? So much for "going green"...

  • Report this Comment On February 27, 2014, at 5:46 PM, RobertC314 wrote:

    The segment on Bitcoin mining makes several fundamentally incorrect statements. Mining is one of the market systems that regulates the value of a Bitcoin: you are supposed to be able to "make a profit" mining bitcoins if the value rises (thus, as demand increases, so does supply, just like precious metals). As to the comment on Moore's law, each bitcoin is harder to mine than the last, and ultimately there will be no more bitcoins to mine anyway (I think the number is 21 million, but I'm not positive I'm remembering correctly).

    The issue, however, is that Bitcoins are based on trust: trust that the software/network is "unhackable" (I'm not knowledgable enough to know if that is the case or not). As for the exchanges, I'm curious to know if the hackers stole Bitcoins directly from Mt. Gox, like an old fashion bank robbery, or if they somehow hacked the Bitcoin software itself, the equivalent of creating their own printing press. One would be an isolated incident, and the other could end Bitcoin for good

  • Report this Comment On February 27, 2014, at 6:16 PM, twistcraft wrote:

    With virtual currency the value is derived from the network infrastructure. You are offered a service, which is a decentralised funds transfer. Sure, the existing value was derived by market speculation alone, and there are still not nearly enough retailers that accept bitcoin payments. However, it can be noted that a number of large firms and several retailers accept this form of payments already.

    As far as the international transfers go, bitcoin is much more convenient than anything else offered in a large number of cases, and a lot cheaper too (in Australia you pay 2% fee to buy bitcoins and that's it). IMHO a number countries like Argentina and Cyprus will float the rate until more businesses will start accepting it, and we will see it grow another 500% by the end of the year. It's not going away yet (there are no security flaws in the protocol itself), and there are plenty of people willing to speculate on the exchanges despite the associated risks.

    I remember that when it was $200-300 couple of fools made a video, joking how useless it was. I've invested 10k into it in 2011, and useless or not, but it was the best investment in 2011, 2012 and probably 2013 just as well. Why am I optimistic?

    1) There is definitely a need in bitcoin, because paypal is not a nice way to transfer funds on the internet since it charges 10% for escrow alone. Internet age has long since come, so why are we still using the transfer methods that take days and cost from $35 per international transfer?

    2) The interest is only increasing in the past several years, and most people still haven't heard about it (understand how it works)

    3) There are way too many people who cashed in millions in this bad craziness, and most of them are too eager to go for the second go-round, so if it drops below $200-400 there are way more people willing to buy then to sell

    Mt.Gox proved itself to be a bunch of scam artists ages ago, when they were shutting down the exchange during any price volatilities. I pity anyone who still had their money there after they refused to provide cash withdrawals, but seriously, what were you expecting?

  • Report this Comment On March 01, 2014, at 6:14 PM, Tiingall wrote:

    The existing banking system is known to be a corrupt and criminal operation. The regular government fines and sanctions are the evidence. But the problem is the banking executives making the decisions to trade in illegal drugs, illegal weapons and to illegally provide cash to terrorist organisations do not pay the fines. We pay the fines via higher fees, lower service and lower returns on deposits.

    See a recent MF article on the long term unemployment crisis for comments. Comments from MF members highlighted that the Federal Reserve and Bank of London (along with all but 3 central banks in the world) are foreign owned private businesses. Nations "borrow" from these private "banks" because governments in the past legislated to give them sole authority to print the local currency. Most of the federal income tax collected from taxpayers in the USA is used to pay back these "borrowings"; not to create any benefits for the citizens. The foreign banking families which own these monopoly companies simply run a printing press to create cash and sell it to the government for face value plus interest.

    There is no gold - or anything else - backing these currency notes. It's simply that we think we can these pieces of paper as a convenient means of exchange for goods and services.

    The fact that we have no choice but to trust them gives the foreign owned central bankers - along with the corrupt and criminal regular bankers - the power to charge us amazing fees for simple services (eg $35 for a Telegraphic transfer) and to pull scams such as routing the payment via an intermediary bank, to extract more fees. For example I paid $35 to send $100 to setup an on-line banking service, but my bank claimed they routed the money via another bank - as an excuse to steal my money - so only $60 arrived. In total, $70 of fees to deliver $60. I threatened to lodge a Police report about stolen money and suddenly my missing $40 materialised. And I got back my fees because they failed in their contractual obligation to provide the offered TT service.

    The present system of creating and printing what we know as money is fake. The management and movement of that fake money, is completely corrupted. The banking rules encourage criminal activity, gross financial negligence and reward theft and greed with million $ salaries and bonuses. A very minor run on the banking system would cause all banks to close tomorrow; because they could not get the printing presses working fast enough.

    They are only operating because we continue to support their corrupt, criminal and thieving activities because we are afraid that if we pull out, we will suffer too much because our own lives are entwined with them; especially if we have a housing loan, or a large deposit with them. If they go down, we go down. That's what keeps the criminals and psychopaths who manage and own the banking businesses and gives them their power over us all. Their system dominates and controls us, not because we trust them and think they are honourable and competent people, but because of our fear of the consequences if we question or threaten them. (Like we rarely challenge the tax office because of fear of retribution.)

    Bitcoin - or other virtual currencies - can have the same trading convenience as cash, and cost us billions and billions less, every year. And give us freedom from the financial oppression.

    Imagine how massively better off we'd all be if governments around the world were not using a very high proportion of our tax money to pay off the "loans" from their foreign owned central banks - eg: the USA's Federal Reserve and the UK's Bank of London - for these private banks creating - with some paper and ink - the cash we use each day.

    Paper and ink is all that is required for the monopolistic central banks to create the money used every day. It must cost them less than a 1 cent to make a thousand $ note, but we must labour to create a thousand $ of saleable goods or services, to get one of those notes to then pass it to the tax man,so they can give it back to the central bank, plus lots of interest (also created by our labour).

    Bitcoin and other virtual currencies are the means to free ourselves and the future from the present yoke of exploitation and criminality imposed by the existing banking system. Imagine what your life would be like if your income tax bill was at least halved each year and you were working for yourself and your family, not to create massive wealth for a foreign banking family.

    Get smart, do some research into why Jefferson said "banks are more dangerous than standing armies". And check if the deliberately misleading name used for the central bank in your country is a front for a private businesses owned by some European banking families.

    Do an internet search and read "The History of the Money Changers". Search out how many government employees and politicians, and ex staff of the central bankers suffered sudden and unexpected deaths when they challenged the monopoly of these private banking families.

    And start using Bitcoin - or other virtual currencies - to replace the cash created, controlled and manipulated by these criminals. Bypass their monopoly control by trading directly with each other for goods and services via the internet, without their charges, fees and corruption.

    Reduce the national debt by using Bitcoins - not paper cash - to trade goods and services. Everyone - apart from the foreign banking families - will benefit enormously.

    And call your politician to demand the country uses Bitcoin - or prints it's own paper cash - rather than buy notes from the foreign owned central bank. We'll all be massively better off without the incredible national debt and subsequent massive personal income tax burden.

    This is what Jefferson said:

    "I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs."

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2854548, ~/Articles/ArticleHandler.aspx, 9/23/2014 2:31:34 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement