MtGox, once a pillar of the Bitcoin exchange market, filed for bankruptcy on March 10. In February, the website had ceased withdrawals before ceasing all transactions at the beginning of March. The fallout from the Mt. Gox collapse will bring up many debates about the need for bitcoin exchange regulations, not to mention the bitcoin network’s long-run viability. It is best to understand what actually occurred with MtGox before jumping into action.
MtGox enabled account holders to exchange bitcoins for dollars and vice versa. Within the bitcoin currency network, there are many different exchanges, but MtGox, at one point, controlled about 80 percent of the market, giving it significant influence over the bitcoin market.
MtGox was created back in 2011, with its name as an acronym for Magic the Gathering Online Exchange, named after a trading card game by the same name. From the beginning the site had trouble with security, and was subject to a series of attacks.
One of the most significant events for the exchange occurred in May 2013 when the U.S. Department of Homeland Security (DHS) seized $5 million worth of bitcoins. DHS argued that MtGox had failed to properly register as a money service business. MtGox followed up by registering with the Financial Crimes Enforcement Network (FinCEN), a government agency that regulates monetary industries such as banking to counteract crimes like money laundering and trade in illegal goods.
The downfall came when MtGox ceased withdrawals on its exchange in early February 2014. The exchange’s stated reason was that it had discovered a flaw in the protocol known as “transaction malleability.” This is a form of fraud that works as follows.
When people exchange bitcoins for goods or dollars, these exchanges are logged onto the “blockchain” a public ledger. Transaction malleability is the ability for users to crack into the blockchain, before transactions are verified, and change the data being put into the ledger system. Then, when the altered transaction “clears,” the user could complain to MtGox that the transaction didn’t go through and be reissued the original transaction.
The result for the exchange was that bitcoins went down in value from over $600 prior to the cessation to about $130 afterwards, at least within the MtGox exchange. Valuation by other exchanges remained unaffected.
In early March, MtGox CEO Mark Karpelès resigned from the Bitcoin Foundation, an advocacy group for the technology. Several days later, transactions on the website were shut down completely, and by the end of the week the entire site was shutdown, with a single front page notice stating that the exchange was being closed indefinitely due to “security issues.”
MtGox has not made any further comments about its decision to cease transactions. Several hackers decided to investigate the situation for themselves, leaking internal documents and tracking the blockchain for trades conducted by the MtGox main wallet addresses. A bitcoin wallet is an account address given to registered users that allows for the transfer of bitcoins between accounts. This is different from “cold storage,” where bitcoins are stored on a hard drive or other device, typically offline to prevent theft. These amateur investigations have revealed that MtGox is deeply in debt. That is why the company was forced to file for bankruptcy on March 10.
Of the theories floating around message boards on the subject, several seem feasible. One theory is that MtGox was hacked into and bitcoins were stolen over time. Another theory conjectures that MtGox began a fractional reserve style system and promised more bitcoin sales than it could afford to sell. A third theory is that MtGox simply lost the money. Which of these theories is correct remains to be determined, but observers remain suspicious.
A solution will and must be provided by market forces. Many bitcoin enthusiasts have vocally opposed an intervention by government regulators and often rallied around chants of “creative destruction!” For a currency that seeks to remain private, the fallout and response to MtGox appears to be just another step in the evolution of the crypto-currency industry.