Mt. Gox Bankruptcy Will Force Changes In Bitcoin

On Friday, Mt. Gox filed for bankruptcy protection.

This announcement doesn't surprise anyone who has been following bitcoin since May 2013, when Mt. Gox started having issues processing withdrawals. Instead of surprise we should be asking why?

Many people lost life changing amounts of money – money to pay off college tuition, money to start businesses, money to pay legal fees, money to pay off mortgages and the list of tragedies go on.

The staggering amount of money that appears to be stolen - almost $500 million at today's prices - pales in comparison to the $3 billion drop in bitcoin's market cap this month caused by Mt. Gox's bankruptcy. This mismanagement caused too much damage to be ignored.

Bitcoin was Invented to Avoid Third Party Trust

The message forever encoded in bitcoin by it's creator in the first coin's ever mined states: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” Bitcoin's reason for existence is to empower users with their own finances. The first sentence of the bitcoin whitepaper states: “Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments.”  If bitcoin exists to remove a need for trust, how did users entrust $500 million with Mt. Gox?

Bitcoin is Regulated in the US

Bitcoin is regulated. Bitcoiners still have to report taxes, bitcoin exchanges need to comply with Banking Secrecy Act and SEC regulations. Those who don't risk prosecution like Trendon Shavers and Charlie Schrem.

Why Did This Happen in a Regulated Environment Designed to Avoid Trust?

Before exchanges early bitcoiners sent envelopes of cash in the mail to someone they had only met online to get bitcoins. The bitcoins they got increased in value from pennies to hundreds of dollars in a few short years. This created a high-risk high-reward culture. With business conducted globally and online, the primary way to tell a scam from a legitimate opportunity was by the operator's reputation.

See also: The Real Gox News - Do Financial Regulations Harm Americans?

This mix of newly minted millionaires, easy money, and a culture of trust made fortunes for  mismanaged companies like Mt. Gox and the pseudonymous and irreversible transactions enabled outright frauds like Ponzi schemes and long cons. Assets for customers skyrocket day after day for months – until one day they vanish with messages citing hacks or legal reasons for the closure.

So why did this happen? The Siren's call of easy money prompted many to trust Mt. Gox, with their history of disasters, with large sums of money while waiting for a well run US based exchange. Regulations made running a US based exchange for an unproven digital currency expensive and high risk. Mt. Gox took advantage of lower compliance costs to setup a Japanese bitcoin exchange and customers reluctantly flocked there to make bitcoin fortunes seeing no good alternatives.

What Will Change?

Today's regulations are primarily old laws applied to cutting edge technology. There will be digital currency specific regulations forthcoming. This week US Senator Manchin began calling for a ban on bitcoin. New York Finance Regulator Benjamin Lawsky has committed to proposing a regulatory framework this year. Regulators will use facts from the Mt. Gox bankruptcy to point out flaws in the bitcoin ecosystem.

They will use heart wrenching stories of those who were unable to start companies, unable to pay for mortgages, or lost marriages to bolster the case for regulation and oversight. Regulators will make compelling arguments and there will be new digital currency regulations.

There will also be free market solutions. Decentralized currency exchanges, insured exchanges, bonded exchanges, radically transparent exchanges with realtime solvency reports are just some of the projects being worked on today. Fraudsters like Bernard Madoff show regulations can't eliminate financial crimes. Mt. Gox's collapse begs the question - can bitcoin provide more safety for consumers or are imperfect regulations the best we can do?

Whatever the eventual solutions, the Mt. Gox bankruptcy filing harshly warns investors to keep a careful eye on their portfolio allocations, the companies they trust, and to beware the siren's call of easy money. Change is coming, but today bitcoin is improperly regulated and retains some of the weaknesses as the system it was designed to replace.