The closure of the Bitcoin (BITCN) exchange Mt. Gox has scared a lot of people, and hurt some who held Bitcoins on the exchange. What happened is a shame and possibly a crime, but it doesn't really speak to the viability of Bitcoin as a form of currency. If a bank closed in the U.S. due to embezzlement would we conclude that the U.S. dollar is non-viable? Of course not.
Diametrically Opposite Views
A recent article on SA "Get Out of Bitcoin Now" began by asserting that Bitcoin was not viable due to security risk, and that the currency was borderline illegal. Assuming that the author was referring to legality in the U.S., I take diametrically opposite views.
Bitcoin and other digital currencies represent yet another example of a disruptive technology, which, by virtue of its novelty is not well understood by many business and technology writers. Let me first deal with the issue of the U.S. government's attitude towards digital currency.
Anticipating the Future
As I point out in my article, "The Future of Digital Currency," private, non-government backed currencies have a long history in the U.S. In the 1800s, private banks issued "bank notes," paper currency backed by the bank. Even today, the personal check is a form of private currency, backed by the user's bank.
Far from being hostile to digital currency, Federal Reserve economists were anticipating the advent of digital currency as early as 2007, a year before the birth of Bitcoin. This is documented in a review by Federal Reserve economist Bruce Champ entitled "Private Money in Our Past, Present, and Future." The Champ article is very readable, non-technical, and great for getting historical perspective on Bitcoin.
Although the image of Bitcoin has been tainted by association with criminal activities, the U.S. government has been careful to draw a distinction between prosecution of those activities and its attitude towards digital currency. The recent arrest of BitInstant CEO Charles Shrem for money laundering is a good example. In regard to the case, Manhattan U.S. Attorney Preet Bharara stated (as quoted from Time):
As alleged, Robert Faiella and Charlie Shrem schemed to sell over $1 million in bitcoins to criminals bent on trafficking narcotics on the Dark Web drug site, Silk Road. Truly innovative business models don't need to resort to old-fashioned lawbreaking, and when bitcoins, like any traditional currency, are laundered and used to fuel criminal activity, law enforcement has no choice but to act. We will aggressively pursue those who would co-opt new forms of currency for illicit purposes.
Bharara makes it clear that the U.S. government doesn't consider there to be anything illegal about digital currency per se. My view on Bitcoin's legality: Bitcoin and other digital currencies in the U.S. are perfectly legal and there is no reason to be concerned that the U.S. government will change its attitude.
When Mt. Gox halted withdrawals, it pointed to what it claimed was a security flaw in the fundamental Bitcoin protocol that it claimed had allowed hackers to make unauthorized withdrawals from Mt. Gox. This is the so-called "transaction malleability" issue.
Bitcoin critics were quick to pick this up as proof that Bitcoin had serious security problems that made it undesirable to hold or trade Bitcoins. In retrospect, it appears far more likely that Mt. Gox was using the issue as a smokescreen to conceal its impending insolvency. Whether that insolvency is the result of theft, from within or without the company, remains to be seen.
I reached this conclusion based on the following:
Technical: I have yet to see any credible technical description of transaction malleability that says it can actually be used to steal Bitcoins from anyone's wallet, either privately or institutionally held. On its website, the Bitcoin Foundation does acknowledge that transaction malleability can be exploited to interfere with transaction processing in a form of "denial of service" (DOS) attack, but even this doesn't result in actual theft.
The Experience of Other Exchanges: Some exchanges, such as BitStamp, did experience the type of DOS described above but were able to make software mods and reopen in a few days. No Bitcoins were stolen, according to BitStamp. The exchange I use, Kraken, never shut down or interrupted service in any way.
The operator of Silk Road 2.0 did recently announce that $2.7 million in Bitcoins were stolen due to transaction maleability. I consider it likely that the Silk Road operator simply made off with the money.
My view on Bitcoin security: It's likely a non-issue in terms of actually compromising a Bitcoin user's wallet or allowing actual theft of Bitcoins.
The Silk Road theft does point out an important caveat that anyone buying or holding Bitcoins, or any other digital currency needs to understand. Bitcoin's creator, the pseudonymous Satoshi Nakamoto, clearly intended to enable e-commerce transactions without resorting to a traditional bank or other financial institution. As a medium of exchange, digital currencies work well. The institutionalizing of Bitcoin through the creation of exchanges represents something of a perversion of this intention.
Nakamoto designed Bitcoin to work as much as possible like cash. Like cash, Bitcoins don't know who owns them, and the whole Bitcoin system only tracks Bitcoin ownership through anonymous numerical addresses. Like cash, Bitcoin transactions are non-reversible. If you want your Bitcoins refunded, all you can do is ask politely and hope for the best.
Making a Bitcoin deposit at an exchange is like making a cash deposit at a bank. You're trusting the bank or exchange to keep track of your deposit and give it back to you on request. Those who made Bitcoin transfers into Silk Road were treating a criminal enterprise as if it were a bank. Not a good idea.
Does the fall of Mt. Gox portend the end of Bitcoin? Of course not. When last I checked on Kraken, Bitcoin had bounced off its post-Gox low of $485 and was trading at about $585.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.