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After the Mt. Gox Collapse, Wall Street is Wary of Bitcoin

In the wake of the Mt. Gox bankruptcy filing, Wall Street firms are unlikely to get involved in virtual currencies unless there is regulatory oversight.

The sudden shutdown of Mt. Gox, the world’s largest Bitcoin exchange on Monday, has raised concerns about theft, fraud and security flaws in the digital currency world, but it has also led to a bankruptcy filing and the admitted loss of nearly $500 million in virtual coins.

The mystery surrounding the Mt. Gox collapse quickly unraveled today with a bankruptcy filing in Japan disclosing that it ‘lost track’ of nearly $480 million worth of the alternative currency. At the Tokyo bankruptcy court, Mt. Gox CEO Mark Karpeles, reportedly blamed the firm’s collapse on ‘a weakness in our system,’ according to a Reuters report.

“I think it’s a tremendous blow to Bitcoin and I think the trust in the currency has diminished,” said Darren Hayes, a professor at Pace University’s Seidenberg School of Computer Science and Information Systems in New York, in an intervew. Hayes points to the drop in the exchange rate for Bitcoin since the virtual exchange went offline. Shaken by Mt. Gox’s demise, investors knocked the volatile currency down to $490, but by Wednesday it had recovered to $564.02, an increase of 5.5% from Tuesday’s close on the CoinDesk Bitcoin Price Index, according to a MarketWatch article.

It’s not really possible to understand what happened to cause the loss, said Hayes. Initially, Bitcoin hinted there was a bug in the system and there was speculation that the system was hacked.

Bitcoin has been the target of scrutiny for the past year, since it’s anonymity made it a suitable form of payment for illicit activities. In 2013 the U.S. FBI shut down the Silk Road online black market, known as the ‘eBay of drugs’, and seized 144,000 bitcoins worth $28.5 million at the time.

Cryptocurrency Should be Secure In theory, Bitcoin should be more secure in a way than other currencies, because of the cryptography involved, argued Hayes. But, Hayes, concedes, this could be a case of fraud, a case of hacking or a one-off situation.

[To learn more about how banks are preparing for and responding to security incidents, attend the Acknowledge the Inevitable: How to Prepare For, Respond to, and Recover from a Security Incident session at Interop 2014 in Las Vegas, March 31-April 4.

Bitcoins are both a payment system and a digital currency created in 2009 by a cryptographer under the pseudonym Satoshi Nakamoto, whose idea was to create a global currency that could be transferred around the world in minutes. Using open source software, he designed a decentralized system such that no central computer is running it and is instead distributed across a network of Bitcoin users. “There’s a mathematical algorithm around this peer-to-peer cryptocurrency and therefore in theory it should be a lot more secure,” contended Hayes.

Regulators and Wall Street

Experts like Hayes say the lack of involvement by governments, regulators and financial services firm has added to the uncertainty surrounding Bitcoin and other digital currencies.

Even after the sudden shutdown of Mt. Gox on Monday night, Japanese officials remained silent.

“From what I’ve read, it seems that the Japanese authorities are not going to get involved in the case,” said Hayes. “There is no government backing for Bitcoin by any government in the world. It leaves Bitcoin in a precarious place,” he said.

“It’s not just a willingness to get involved, the issue is it’s difficult since there is no paper trail,” said Hayes. It’s not like money being transferred from one bank to another, we’re dealing with a cryptocurrency so it’s difficult to figure out whose exchanging coins with you,” he said.

One of the biggest problems for Bitcoin and other virtual currencies is that financial institutions have not been involved with the currency. “Financial services won’t get involved until the US government takes a position on virtual currencies,” said Hayes. While there was a congressional hearing last fall on Bitcoin and other virtual currencies, with some venture capitalists investing in funding virtual currency companies, no one has heard from the Obama Administration or Congress, he said.

One cop on the beat is the Financial Crimes Enforcement Network (FCEN), a Treasury department unit that tracks money laundering to stop terrorist financing and other financial crimes. FCEN has said that transacting Bitcoins for one’s personal use is not illegal and it’s not illegal to have the software for mining bitcoins. However, any firm acting as an exchange or as a third party for virtual currencies are in the money services business and need to file reports with the FCEN under the Bank Security Act (BSA).

Several regulators have recently begun to examine virtual currencies, including the Commodity Futures Trading Commission. Manhattan U.S. Attorney Preet Bharara has sent subpoenas to Mt. Gox, reportedly to investigate bitcoin exchanges on how they handled recent cyberattacks, reported Reuters. Three exchanges, including Bitcoin, were forced to halt withdrawals of the virtual currency on Feb. 7 after being hit by distributed denial of service attacks.

Hayes suggests that Wall Street firms are “itching” to get involved because of the volatility in the prices of Bitcoin, noting, “There is money to be made.”

Fraud or Ponzi Scheme?

Wall Street hedge fund manager Bruce Richards, CEO of Marathon Asset Management, went so far as to call Bitcoin, a “Ponzi scheme and a fraud,” when he appeared on Bloomberg Television’s “Market Makers,” on Monday after the Mt. Gox collapse. He noted the creation of the Euro which “took a decade or two to create with 17 countries backed by a reserve currency, “ said Richard. “To have Bitcoin, which is produced by a computer —which no one knows how to produce except a few people who have algorithms — and then trade it and have it be worth a currency that you can exchange, is a bit of stretch, don’t you think?” asked Richards. “This is something on our computer you can create out of thin air just by programming algorithms and people can trade it, “ he said. While there are other Bitcoin exchanges that have grown and attracted traders, Richards said, “I always thought it was a Ponzi Scheme, a fraud, and I don’t think it’s a viable currency.”

Despite the concerns about security, Hayes says it’s not the end of virtual currencies because Bitcoin is not the only virtual currency being used by millions of people. In the broad scope, there will not be any death or demise of virtual currencies in the near term," he said.

On the same day that Mt. Gox went dark, SecondMarket, said it planned to launch a regulated Bitcoin exchange for major banks that would involve regulatory oversight. The announcement was seen as a positive for Bitcoin since SecondMarket has a successful track record running private markets for shares of Twitter and Facebook. Such a move could bring more structure and transparency to Bitcoin, and attract established financial institutions to trading virtual currencies.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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