Mt. Gox Bitcoin Exchange Collapse

bitcoin exchange

When the Mt. Gox bitcoin exchange collapsed yesterday, there was a lot more going on that met the eye. At present, it seems that thousands of people are going to be out hundreds of millions of dollars….and no one seems to know where the money went.

There was never anything original  in the bitcoin concept. It is really not much more than a credit or debit card….without the card. Funds are stored electronically as credits in your account, and when you choose to buy something, the funds are debited from your account and credited to the seller’s account.

With a credit or debit card, there is a two step encryption process. The first step is to record the card number, which is contained on the information strip on the back of the card. The second step is for the customer to provide  proof of identity by entering a pass code on a keypad or signing a receipt that authorizes the withdrawal of funds from the account.

Bitcoin accounts are no different. Stripped of its high tech complications, bitcoins are nothing more than electronic promissory notes, like credit card transactions, that are presented in exchange for goods and services, or bought and sold with the local currencies.

There are four elements that make it possible for the bitcoin system to function: a database that lists all bitcoin transactions back to day one, a storage and retrieval system for the data, a “public key” encryption system that allows people who don’t know each other to unlock each other’s bitcoins, and a liquidity system for converting the bitcoins into local currencies. That liquidity system was the Mt. Gox bitcoin exchange’s Achilles Heel, the back door through which thieves gained entrance into the system.

The value of a bitcoin is established by the difficulty involved in creating them.  Individual bitcoins themselves are created by “bitcoin miners” who employ massively powerful arrays of very expensive computer hardware to “break” the encryption codes that guard the bitcoin database.  Whoever breaks the code first gets that bitcoins, which they can then sell at a profit.  The intrinsic value of a bitcoin is based upon the cost of breaking the codes in terms of the cost of operating the bitcoin mining equipment, which is substantial.  What you are really paying for when you buy a bitcoin is the time used up on their processors  and the infrastructure that supports the whole system.   

The bitcoin miners are responsible for maintaining the integrity of the system by constantly solving the encryption codes, which are then added to the database, increasing the layers of security on the system. They provide the infrastructure. 

The exchanges provide access, where the transactional  value of a bitcoin, or its buying power, is determine by the trading of bitcoins on the exchanges.   Multiple redundant computer systems around the world collectively host redundant copies of a database that records the present ownership of each bitcoin, and a complete history of each transaction during which that bitcoin changed hands. The redundancy is essential to preserve the integrity of the system. The storage and retrieval system consists of orders posted via computer to database instructing the database to move bitcoins from one account to another on the basis account holders instructions, and the public key encryption system is supposed to ensure that you are who you say you are.   The exchanges are the banks and the stock exchanges of the system.

The Mt. Gox Bitcoin Exchange collapse is casting doubt upon the integrity of the entire system, despite the efforts of the other major players to portray Mt.  Gox as the bad apple in the barrel, the exception to the rule. 

The major bitcoin exchanges released a joint statement today to reassure bitcoin owners that their investments were safe while attempting to distance themselves from Mt. Gox.  This contradicts the basic premise of the bitcoin system which suggests that what affects one exchange should affect them all because the bitcoin vendors are tied together by the same global database that records all bitcoin transactions.

Mt. Gox was originally founded in 2009 as an online exchange designed to facilitate the purchase and sale of cards from Magic:The Gathering, a popular trading card game. The rationale behind the exchange was simple. People who wished to buy or sell their Magic cards needed a way to conduct those transactions safely. By acting as a trusted middleman between buyers and sellers, Mt. Gox could facilitate transactions, guaranteeing that the goods would be delivered to the purchaser and the payments would go to the seller. In 2010, the company redefined itself as a bitcoin exchange, setting itself up to clear bitcoin transactions.

There is an long-standing alliance between gamers, computer hackers, card traders, and fantasy game players, many of whom share an egalitarian, anti-authoritarian belief system that the bitcoin movement played into. Other, less Utopian players simply wanted a monetary exchange system that was exempt from the prying eyes of governments and tax collectors. And then there are the speculators, for whom the bitcoin was a dream come true.

The company came to grief after a series of events that demonstrated the instability of the system, including one in which a hacker gained entry to the system and issued a massive “sell”order that drove the price of the bitcoin down to one cent before Mt. Gox was able to correct the problem. The wild fluctuations in the value of bitcoin resulting from the probably irresponsible behavior of the company’s owners made crystal clear what critics of the system have been saying all along. “There is no there there.”

The Mt. Gox Bitcoin Exchange collapse  is a refutation to the belief that bitcoin trading is safe. It’s anything but. One bitcoin exchange executive put it bluntly. “When you buy a bitcoin today, you should be prepared for it to be valued at zero tomorrow. If you can’t handle that, don’t buy bitcoins.”

By Alan M. Milner

Sources:

Bloomberg/Business Week
NPR/Associated Press
Washington Post

 

 

One Response to "Mt. Gox Bitcoin Exchange Collapse"

  1. Bill Patterson   March 3, 2014 at 1:33 pm

    I’m afraid the current (and ongoing) enthusiasm for bitcoin may be premature.

    Reply

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