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.
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.
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.
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!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.