Bitcoin Banking by David Howden

David Howden provides a preliminary post mortem of Mt. Gox.

A currency is only as safe as the bank that stores it. Nowhere is this more apparent than in the recent turmoil in the bitcoin community.

On 7 February of this year, Mt. Gox – a bitcoin exchange which essentially functioned as a depository (i.e., bank) for bitcoins – halted all withdrawals in the crypotcurrency. At the time I wrote two articles making a pretty clear case for Mt. Gox operating like a run-of-the-mill fractional-reserve bank (here and here).

Fractional-reserve banks that existed before the advent of deposit insurance were constrained by some real pressures as they decreased their reserves. As depositors became less sure that they would be able to access their deposits on demand, they would start demanding the fractional-reserve bank’s services at a discount to its competitors. As depositors started withdrawing their funds and endangered the liquidity and eventual solvency of the bank, the bank would react by either halting withdrawals outright (as Mt. Gox did on February 7), or temporarily delaying them while remunerating the client with an interest payment (i.e., enact a “option clause”, something Mt. Gox effectively did by charging clients an extra fee if they wanted their withdrawals expedited.)

The claim that Mt. Gox was operating with fractional reserves came as shocking to some. After all, the exchange functioned by providing a shared wallet for depositors. Each time a deposit was made in bitcoin, the proceeds were moved to the shared wallet. This wallet was safely stored offline (“cold storage”) so that hackers could not gain access to them. In addition, a very high percentage of bitcoin was supposedly stored in this way – up to 98% by some claims – with only a small amount held online to facilitate withdrawals and other transactions.

In theory, since almost all of the bitcoin were held safely offline by Mt. Gox, the “bitcoin bank” should have been behaving like any standard full-reserve bank. The evidence over the past months proved this to be anything but the reality of the situation.

Mt. Gox believes “there is a high possibility that the Bitcoins were stolen.” As far as I am concerned, it doesn´t matter too much if the bitcoins were stolen by a third party, or used in some way by Mt. Gox as would be the case with most other fractional-reserve banks. The fact of the matter is that the bitcoins are not in the vault, and that has created the difficulties the exchange´s clients currently find themselves embroiled in.

The entire article can be read here.

The last paragraph above is key to Howden’s line of reasoning. Mt. Gox has been intimating that its demise was a result of theft. If claims about cold storage of bitcoins are true, then Mt. Gox’s explanation is invalid and they are embezzlers, the same as any other fractional reserve bank.

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