By David Nelson, CFA
Reuters is reporting that Bitcoin bank Flexcoin is shutting down after being robbed of about $600,000 by hackers. Flexoin, based in Canada is working with authorities to return coins held in cold storage. The term refers to computers not connected to the internet and therefore can’t be hacked.
In a tweet following Mt. Gox’s shutdown Flexcoin said “While the Mt. Gox closure is unfortunate, we at Flexcoin have not lost anything,” Obviously that didn’t last long.
The Collapse of Mt. Gox and robbery at Flexcoin has sent a shockwaves around the world. On Friday, Mt. Gox filed for bankruptcy protection saying they’ve lost 750,000 customer bitcoins along with 100,000 of its own. That’s a loss of about $473 Million. They now say they have outstanding debt of $63.6 Million.
In a recent interview on Al Jazeera America, I said we may find months from now that Mt. Gox was nothing more than a Ponzi scheme. While the exchange has filed for bankruptcy protection saying they were the victim of theft, I’m still holding to my remarks. I have no direct evidence but this just doesn’t pass the smell test. The founder and CEO Mark Karpeles has resigned saying they were hacked and robbed. There had been customer reports claiming that transactions were getting increasingly slow. You could get your money in, but couldn’t get it out.
Ponzi?
As for Mt. Gox, it doesn’t look like I’m alone with my fears. At bitcointalk.org a website where bitcoin enthusiasts go to chat, an informal poll was taken. 43% believe Mt. Gox was a Ponzi scheme.
Ponzi schemes are rarely started with fraud as their original intent. It generally comes about as the business model fails. Sometimes the Ponzi is meant to be temporary, thinking they can perpetrate the fraud just long enough to turn the ship around. Even though evidence suggests that Bernie Madoff’s operation became a Ponzi as far back as the 70’s, I suspect it didn’t start as one.
Now that Mt. Gox has filed, some important questions need to be answered.
- What about the last investors to get out whole?
- How were they paid off?
- Were the last to leave paid with funds held in custody or with new money coming in?
If we find out they were paid off with new investor money that meets the definition of a Ponzi scheme.
SEC Definition of a Ponzi scheme: A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors.
Bitcoin on the Hill
In Washington West Virginia Senator Joe Manchin sent a letter to Treasury Secretary Jack Lew, Fed Chairwoman Janet Yellen and a host of other financial regulators demanding they “take appropriate action to limit the abilities of this highly unstable currency”
Senator Manchin is also very concerned about the use of Bitcoins on illicit sites like the Silk Road and other black markets. It looks like he is going to push for an out and out ban pointing to China and Thailand who have made the currency illegal.
In Senate testimony Fed Chairwoman Yellen told Senator Manchin that her agency “simply does not have authority to supervise or regulate Bitcoin in any way.”
U.S. Attorney for the Southern District of New York Preet Bharara has also stepped in sending subpoenas to Mt. Gox and other exchanges as well as businesses that deal with Bitcoin.
I think this is just the beginning. Bitcoin is big news and that means lots of media attention. Now that Senator Manchin and District Attorney Bharara have stepped forward, I think we are going to see a wave of politicians and regulators launch their own investigations.
Mt. Gox vs. Bitcoin
It’s important to distinguish between Mt. Gox an exchange and Bitcoin the currency. I doubt we will know anytime soon what actually happened.
Despite what are obviously significant blows to Bitcoin, I think the currency can survive. The volatility has been extraordinary with 20-50% moves not uncommon. Now many supporters of Bitcoin are calling for regulation and oversight. I suspect if they let Bitcoin to continue to operate here in the states we are going to see legislation and regulatory oversight. Without it I think it is important for potential investors to understand that they have no protection. Bitcoin exchanges aren’t backed by any legal entity.
Origins of Bitcoin
The development of Bitcoin came about in 2009 as a form of computer generated crypto currency. Basically it is a peer to peer payment system. Bitcoin Miners verify and record payments in exchange for transaction fees. The appeal was that only 21 million Bitcoins could be created and that transactions would remain anonymous.
After the financial crisis central banks around the world began printing money. This created the backdrop for an alternative currency to gain in popularity. In the past gold has played that role but to the best of my knowledge not a single currency is backed by the yellow metal. Criminals love Bitcoin because it allows them to launder money and finance illegal activities without leaving a paper trail.
While Bitcoin may be one of the first crypto or digital currencies I doubt it will be the last. JP Morgan filed a patent for a payment system that has a lot of the features of Bitcoin.
Private Market Solutions
The Bitcoin industry could use some sort of private market insurance. One novel approach is offered by London startup Elliptic. They advertise a secure vault for bitcoins and that they are insured by Lloyd’s of London.
Prior to the crisis at Mt. Gox libertarians had embraced the lack of oversight and government regulation. Now with the losses mounting I suspect many would like to see at least some financial controls. Perhaps the best model may come from the private market with some government oversight. Just sayin, as it stands now; “How many Bitcoins do you want to buy?”
