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What Is Bitcoin and Its Current Crisis?

The virtual currency’s once largest exchange, Mt. Gox, has abruptly shut down. A bitcoin expert explains the potential impact


What will become of bitcoins?
Courtesy of Casascius, via Wikimedia Commons

Problems at the Tokyo-based Mt. Gox bitcoin exchange, once the world’s largest, have come to a head, leaving the virtual currency and peer-to-peer payment system in a state of flux and threatening to undermine much of the acceptance bitcoins have garnered over the past year or so. The Mt. Gox Web site has been shut down, and the organization’s Twitter feed has been cleared amid reports that the exchange was hacked, resulting in the theft of hundreds of thousands of bitcoins.
 
Bitcoin value fluctuates, but currency conversion Web sites indicate that the more than 744,000 bitcoins taken could be worth as much as $386 million as of Tuesday. Details are scarce, particularly with Mt. Gox having gone dark, but if that number is correct it means about 6 percent of the 12.4 million bitcoins created since the currency’s inception in January 2009 have been taken out of circulation.
 
Mt. Gox’s fall has been messy, much to the chagrin of the rest of the bitcoin community. The exchange claims that the cybertheft of bitcoins from its computers has taken place over a period of years and is at least in part the result of a flaw in the bitcoin software. Bitcoin developers dispute Mt. Gox’s claims that their software has inherent security flaws. Meanwhile, despite being a founding member of the Bitcoin Foundation that advocates the virtual currency, Mt. Gox on Sunday vacated its position on the board of directors. All of this has helped sink the value of bitcoins on other exchanges.
 
It remains to be seen what repercussions this turmoil will have on a new U.S.-based regulated exchange for bitcoin investors that would operate like a New York Stock Exchange for bitcoin, where only large institutions can join and trade. The idea is for SecondMarket Holdings to entice big banks to trade in bitcoins, something they have mostly avoided to date because of the currency’s volatility.
 
Scientific American asked Jeff Garzik, one of bitcoin's lead developers and a senior software engineer at Bitpay, an electronic payment–processing system for bitcoin, to explain the potential effects of these latest events on the virtual currency.
 
[An edited transcript of the interview follows.]
 
What are bitcoin’s main advantages as a currency?
Bitcoin is the world's first global, decentralized, digital currency—it is not controlled by any one party, who might be misguided or influenced. For the first time, you may send value (money) between any two parties, anywhere in the world, without a third-party intermediary. This enables, for example, extremely low cost international remittances to anyone with an Internet connection or mobile phone.
 
Bitcoin is also highly predictable. The money supply is controlled by a decentralized software system, releasing new currency into the supply every 10 minutes, until a maximum of 21 million bitcoins is reached. The money supply cannot be inflated or deflated artificially in times of plenty or crisis. This is in contrast with other currencies, whose supply is controlled by humans who may be mistaken, misguided, malfeasant or under duress.
 
And bitcoin is open. Critical to the system's success is the process of peer review and cross-auditing, similar to review processes university chemists use for academic papers. Bitcoin's software source code is publicly available for review, testing and auditing at all times. Bitcoin's transaction ledger, by design, must be public, to guard against double-spending and to ensure system financial integrity.
 
What does a bitcoin exchange do?
There are many bitcoin exchanges , and they serve as marketplaces where users come together to buy and sell bitcoins. The users set the market prices, just like the bid/ask order process for a NASDAQ stock. Some exchange users are simply looking to acquire or sell bitcoins for U.S. dollars or another currency. Other exchange users are active traders, speculators and high-frequency trading robots. Bitcoin's price is discovered through this active, 24/7 process of buying and selling in a multitude of worldwide exchanges. The more exchanges we have, the healthier the ecosystem.
 
What is the advantage to a merchant to accept bitcoins, compared with, say, a credit card?
For merchants, the advantages are clear. Bitcoin is a guaranteed payment, like a cashier's check. If you receive bitcoins, that transaction cannot be reversed at a later date by a criminal seeking to commit fraud. This has obvious advantages for merchants selling goods over the Internet. In addition, Visa, MasterCard and other credit cards cover only about 60 of the world's nearly 200 countries. Bitcoin enables anyone in any country to securely pay a merchant, without the merchant having to worry about fraud risk.
 
How did Mt. Gox become the largest bitcoin exchange?
Mt. Gox was an early exchange and achieved momentum. Running a bitcoin exchange in the absence of a clear legal environment implies that only a few were willing to take that risk. Few exchanges, coupled with momentum, led many users to choose Mt. Gox as the least-worst option. It worked, which was a sufficient bar.
 
The U.S. Treasury Department's FinCEN [Financial Crimes Enforcement Network] issued guidance on bitcoin, starting in March 2013, which has helped clear the legal environment for bitcoin. Bitcoin is entirely legal for normal users to buy, sell or use to purchase goods. You might be subject to income or capital gains tax , but people should consult a certified public accountant for specifics. Some more advanced uses of bitcoin—such as a bitcoin exchange—probably require licensing with FinCEN and with one or more U.S. state regulatory agencies.
 
There seems to be some uncertainty regarding what happened to Mt. Gox. Why would it be difficult for Mt. Gox to determine whether there had been a theft within its exchange?
Only Mt. Gox can answer that question. Mt. Gox's software was closed source, unavailable to the public for independent review and testing.
 
What makes bitcoin exchanges a prime target for cyberattacks?
Exchanges are targets of attacks for the simple and obvious reason: money. Bad actors either wish to attempt a virtual bank robbery or to manipulate one market in an attempt to achieve gains in another market.
 
How accurate are reports that Mt. Gox lost more than 744,000 bitcoins, about 6 percent of the total 12.4 million worldwide?
The state and amount of Mt. Gox funds are completely unknown. We just have one leaked document [labeled “Crisis Strategy Draft”] on top of months of Mt. Gox behavior that worried many consumers.
 
How will this news impact SecondMarket's plans to draw the world's largest banks into the virtual currency market for the first time?
It highlights the need for more responsible players like SecondMarket.
 

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