Mt. Gox May Have Been A Ponzi Scheme (But Bitcoin Isn’t)
Tuesday’s apparent collapse of Mt. Gox, Bitcoin’s oldest, largest and, until recently, most trusted exchange, sent shockwaves through the Bitcoin economy worldwide. While the exchange largely stopped honoring withdrawal requests nearly three weeks ago, closed its Tokyo offices and stopped responding to support requests, it was not until Tuesday that its website went totally dark, taking an estimated three quarters of a million bitcoins with it. US Department of Justice officials announced that they had opened an investigation the same day, though it was not immediately clear what law Gox is believed to have broken. Mt Gox’s website was back online Wednesday, but displayed only a short message stating that the company is working hard to resolve its problems. Customers who had coins held by the exchange have been left with little indication as to when or if they will be able to recover their funds. Now, pundits and Bitcoiners worldwide are asking “could Mt. Gox could have been a Ponzi scheme? “Ponzi scheme” is an accusation that has often been leveled at Bitcoin by its less informed critics. Though the best known example of a Ponzi Scheme is undoubtedly the one overseen by jailed investment manager Bernie Madoff, the name is a century older and the concept is older still. Ponzi schemes are characterized by a few common traits. First, funds are continuously solicited from “investors,” who are typically enticed by high pressure sales tactics touting extra-normal returns and warning that prospects will “regret it forever” if they don’t get in soon. These claims generate both excitement and a sense of urgency, often resulting in victims “investing” more than they can comfortably or safely afford. There may be restrictions or limitations on withdrawals from the investment, which keeps the scheme stable by holding victim funds captive.As the scheme evolves, some early participants are allowed to leave, taking their extraordinary gains with them. Older victims are “paid off” using funds from new victims. Ponzi schemes are often categorized as “affinity frauds,” because the perpetrators use shared background or interests to target specific communities of people. Seeing their peers cash out encourages other victims to stay by convincing them that the scheme is not “too good to be true” and that leaving will carry the opportunity cost of missing out on future gains. Additionally, would-be victims who have made money serve unwittingly as the scheme’s best salesmen, boasting tirelessly about the money they made in the “investment” and convincing others to join. Ponzi schemes can continue for long periods of time, bound only by the amount of incoming funds and the amount of trust enjoyed by the perpetrator. The Bernie Madoff scandal, for example, is thought to have lasted more than thirty years, coming apart only under extreme customer withdrawal pressure stemming from exceptionally unusual market conditions.For the most part, the description of a Ponzi scheme isn’t applicable to Bitcoin. Coins that are stored in a wallet on a computer’s hard drive or in cold storage are accessible only by the owner (or someone else with the requisite encryption key). Anyone can confirm their existence by checking the public address on the Blockchain. When a user sells bitcoins or purchases them from another user, no one loses. When a user converts her coins to fiat currency or trades them for goods and services, what she receive in exchange for them is tangible and valuable. These are common characteristics of any transaction between a willing buyer and a willing seller in an orderly market, not a fraudulent scheme. However, implicit trust begins to erode at the point where bitcoins pass into the control of a third party and thus beyond the capability to immediately confirm or deny their existence.While functionally similar to banks, exchanges and other providers of online wallets or escrow services are generally not subject to bank regulations governing solvency protections and capital requirements. Though they probably lack the legal authority to engage in fractional reserve accounting in the way that banks do, in practice there would be little to stop them from doing so. Since exchanges don’t make loans, the most likely reason that an exchange might engage in fractional reserve accounting would be for the purpose of trading bitcoins for its own profit. However, an exchange might also be forced into a fractional reserve situation by theft, fraud, or some other adverse condition. This is likely to be what happened to Mt. Gox. Whether this occurred due to the seizure of millions of dollars owned by Mt.Gox by the US Treasury during the summer of 2013, due to the so-called transaction malleability problem, or as the result of some other undisclosed issue is likely to be known for sure at present only by Mt. Gox’s management.Customer owned coins at services like Mt. Gox are typically held in commingled wallets, with the bulk kept in cold storage offline. Customer accounting is handled by software that tracks the amounts that each customer has transferred in, purchased, transferred out and sold. The sum of these transactions is the customer’s wallet balance. Most exchanges emphatically deny engaging in any kind of fractional reserve accounting, though the precise balances of customer funds and capital on hand are rarely (if ever) publicly disclosed. The reason for this is simple: since exchanges and trading platforms function in part as closed economies, with users buying and selling the same bitcoins from each other, knowing the depth of the resources at the disposal of the exchange might tempt a rival company or rogue trader to try to manipulate the market there. An example of exchange manipulation would be feeding in buy or sell orders until either cash or bitcoins on hand were exhausted. At that point, the exchange would have no choice other than to liquidate bitcoins on the open market to raise cash or purchase bitcoins on the open market, expending cash. However, deliberate manipulation is not the only circumstance that could cause this- a sudden run up in the price of bitcoins could result in widespread profit taking and cash withdrawals. A sudden and dramatic fall in the price could also cause customers to panic and pull out. Unfavorable government action could drive unusual customer behavior, as could a nasty rumor about exchange solvency or bad publicity for Bitcoin in general.If the exchange were weak, if its cash reserves are low or if it failed to act quickly to restore itself to normal operating conditions under pressure, then it could find itself unable to clear customer orders in a timely fashion. If it were exceptionally weak, short on both cash and on bitcoins, then the exchange could deadlock, being unable to process customer requests of any kind. The exchange would not be able to accept funds from customers to purchase bitcoins that it did not have on hand to sell, nor would it be able to buy bitcoins from customers who want to cash out, since it wouldn’t have the cash to pay for them. As word spread that X exchange is functioning slowly or not functioning at all, customers would start to get nervous or panic. Withdrawal requests would come pouring in and deposits would taper off. In the absence of outside help, the exchange would eventually have no choice but to close its doors, winding down in as orderly a fashion as could be managed.What precisely happened at Mt. Gox this week is not terribly important. If the exchange is down for good, then the events leading up to its fall will be thoroughly investigated. What is important is the question of why it was unable to recover. When did the problems at Mt. Gox first start and why did it seem to melt down in slow motion? Then, once it became apparent that Mt. Gox was in trouble, why was it unable to secure help in the form of bank financing or support from other companies in the Bitcoin community? Mt. Gox CEO Mark Karpeles allegedly asked for it, but was refused. The entire community has something to lose by the outright failure of one of its largest exchanges. While the company’s competitors can hardly be faulted for not being interested in propping it up, its name, customer base and website have substantial value that should have been enough to support some kind of arrangement. Further, with an estimated 750,000 coins on deposit, Mt. Gox is unlikely to be completely insolvent unless its assets were stolen wholesale. Even a small fraction of customer deposits would likely still be valued in the tens of millions of dollars. While it is still early, Karpeles presumably hasn’t found any takers yet. Could this be because something other than simple incompetence is suspected of the management at Mt. Gox?If Mt. Gox is truly out of business, then the circumstances surrounding its fall will be found out, in time. In the long run, this might be better for Bitcoin. If a bailout package is worked out, then the public may never know what happened over the last six months. If Mt. Gox started as a Ponzi scheme or ended up that way over time, then criminal prosecutions are both necessary and desirable. Industry pundits are already predicting that the fall of Mt. Gox signals the end of “amateur hour” in the Bitcoin economy. We should all hope that prediction comes true.