Bitcoin's fundamentals may be solid, but trust is the glue holding the community together, and recent news may have dealt a fatal blow to that trust.
For a while, that trust was growing. Although there had been some incidents from the early days (Bitcoin is only five years old, remember), adventurous merchants were experimenting with accepting Bitcoins for products. Bitcoin ATMs have even appeared (basically, self-contained front-ends to existing exchanges). Financial regulators were starting to wake up, with some for, some against, but all interested.
Unfortunately (or fortunately, perhaps), that is now in retreat. Although the protocol remains secure, the community has started to fracture, with serious rifts appearing and rumours of fraud, insider trading, and market manipulation. Trusting technology, it turns out, is easier than trusting shadowy third parties with your wealth.
Even banks were looking interested. Standard Bank looked into the possibilities of trading Bitcoins, then canned the idea.
What happened is that the weight of bad press finally took its toll. There was no single incident: the Mt. Gox hack was just another in a series of failures, and the nascent Bitcoin industry is now very much on the back foot.
The basic architecture of Bitcoin is still as secure as ever. The cryptographic principles underlying it are still solid, and there are few known flaws in the architecture. The flaws that do exist, like "transaction malleability", are usually avoidable, or merely annoying, rather than open to abuse. That's not the problem. The problem is that trust is going, and may be gone, because the real-world implementations have been spoiled by shaky implementation and criminal activity.
Any currency, alternative or not, can only succeed if it is trusted by the community. No matter how mathematically sound it may be, Bitcoin can only succeed if its own users trust each other, and more broadly, if outsiders (online services, retailers, even banks and financial regulators) trust it enough to transact with it. More and more, it appears they don't. And possibly, can't.
The problems with Bitcoin
There are a number of reasons why trust in Bitcoin was wavering, and may now be over the brink.
1) No protection, and no regulation. As a consumer, or a merchant, there's no government oversight in Bitcoin, and while that's widely regarded as a plus by the Bitcoin community - it's an alternative currency, right? - it's a major downside for anyone who weighs up the risks. And the risks do appear to be very high. The tentative conversations between regulators and Bitcoin proponents have been marred by reluctance to take any regulation on board, and of course Bitcoin is open source and distributed by design: it has no central governing body. The "Bitcoin Foundation" is a third-party body set up to proselytise, with no formal power beyond what the community agrees.
If Bitcoin does survive this crisis of confidence, and isn't red-taped into oblivion by trigger-happy regulators, the community could emerge stronger than ever, just much smaller.
2) Volatility and manipulation. The price shoots up and down with huge variation minute by minute. Over time, with scarcity built into the protocol, it trends upwards, but one hacked exchange can bring the price down with a bump. For a merchant selling in Bitcoin, but buying in dollars, that can really hurt. Setting prices in dollars, but accepting Bitcoins, is largely futile for all concerned, unless your transaction demands the pseudo-anonymity enjoyed by the users of underground markets like Silk Road. Because the exchanges operate on similar buy/sell techniques as real-world stock markets, they are ripe for market manipulation. Arbitrage bots are able to take advantage of fluctuations. Mt. Gox was believed to operate internal bots of its own, which would have had the enormous advantage of advance knowledge of price changes and the ability to operate without transaction fees. It is hard to imagine an exchange operator not running bots, under the circumstances, but whatever the truth, the upshot is that anyone transacting with an exchange is opening themselves up to a great deal of risk, with little protection.
3) Implementation and delays. The interface between the real world and Bitcoin is currently unpredictable, making it challenging for traders. Merchants can wait many minutes for transactions to clear, compared to the relative instantaneity of a credit card. That can become worse if a site is attacked - the transaction chain relies on community validation.
4) Security. Taken as a whole, the Bitcoin community is basically really bad at security. Exchanges get hacked on a monthly basis, with losses in the millions of dollars. The problem is, when you use a Bitcoin exchange, you are taking your trust in the cryptography behind the currency, and swapping it for trust in the exchange operators. On past performance, that's a very bad idea. Not just because exchanges tend to be coded by people who clearly don't know much about security, but because in many cases you don't know who they are at all. When the exchange disappears, taking your money with it, you have no one to call, much less sue.
To be fair, let's assume that at least some of the Bitcoin operators out there are completely honest, well-intentioned, and security wizards to boot, operating absolutely bullet-proof exchanges. Here's the challenge: name them. More specifically, how do you tell them from the rest? That's where trust comes into play, and users burned by the continuous failure of other exchanges are short on that commodity.
Trust no one
Mt. Gox is the poster-child of Bitcoin exchange collapses: the market's most popular exchange went dark recently, and its holding company is now in bankruptcy proceedings in Japan. The inevitable rumours of internal fraud are circulating, while the operators are claiming to have been comprehensively hacked over the course of two years (making them merely hopeless incompetents rather than criminals). And since Gox, Flexcoin followed suit, claiming it had lost 896 Bitcoins to a hacker, and closing its doors. The CEO of another exchange, First Meta, was recently discovered dead in her Singapore apartment, apparently suicide, but investigations are ongoing.
Mt. Gox was preceded by a litany of failures. Gox itself suffered an earlier hack in 2011, but it was hardly alone. Bitcoinica was cleaned out (twice) and eventually shut down. In fact, there have been dozens of similar incidents, with failures ranging from operators losing the encryption keys (taking Bitcoins out of circulation entirely), outright fly-by-night scams, and major hacks (and potential inside jobs) like Mt. Gox.
But the scale of the Mt. Gox debacle made it particularly noteworthy: the exchange's demise is a great deal worse than most of the previous hacks we've seen, and there have been plenty of those. Gox was the most popular exchange, and its alleged hack involved two years of exploitation, 750 000 Bitcoins - about 6% of all Bitcoins in circulation worldwide - worth about half a billion dollars in the exchange rate when the curtain fell. That is, by any reckoning, a devastating blow to the community.
There is one obvious lesson here, and it is that it is enormously risky to trust a Bitcoin exchange. With no regulation and no transparency, a Bitcoin service has only the empty promise of its operators, if you even know who they are.
With Mt. Gox out of the picture, another exchange, BTC-e, is rising in popularity. Its users have presumably forgotten or forgiven its own hack, in 2012, in which it lost around 4 500 Bitcoins. The operators handled the loss well, communicating with users and refunded lost coins, but the incident remains a black mark.
The identity of BTC-e's operators is also a mystery: no one knows who owns and operates the exchange, though it has rumoured links to Russia. But the simple fact is that if BTC-e does a Gox and closes up overnight, whether due to an outside attack or not, taking its users' Bitcoins with it, there would be no redress, no recourse, and no refunds.
Sometimes, knowing the identities of the operators isn't much reassurance. The Bitcoinica exchange was the brainchild of Zhou Tong, a 17-year-old Chinese coder. (Ubitex, a Bitcoin site suspected of being an outright scam, was also operated by a minor: Nathaniel Theis - the clich'e of smart kids operating businesses online is alive and well in the Bitcoin space.)
Bitcoinica was also interesting in that it spawned the first Bitcoin court case, Cartmell vs Bitcoinica, with users suing for their lost funds - no progress in that case yet. Even Mt. Gox was started as a hobby project ("Magic the Gathering, Online eXchange" was created to service trading card enthusiasts) and quickly grew beyond its original creator's control.
So, as a prospective Bitcoin investor or user, where are you going to go? Roll the dice, pick an exchange, and cross your fingers?
What doesn't kill you makes you stronger
If Bitcoin does survive this crisis of confidence, and isn't red-taped into oblivion by trigger-happy regulators, the community could emerge stronger than ever, just much smaller.
Mt. Gox always was a disaster waiting to happen, and now that it's failed the remaining exchanges are likely to be more diligent, and their users will be more sceptical and demanding of better practice. However, that stronger community, as well as being smaller as some give up in dismay, may also be a more isolated one: outsiders are less likely to accept Bitcoins for all the other reasons: volatility, security, transaction delays and so on.
It's entirely possible we'll see internal cryptocurrencies spawned to serve closed communities, and ultimately there is no reason why that shouldn't work, provided the single core ingredient can be delivered: trust. After all, anyone can create their own: just download the Bitcoin source code, tweak a couple of parameters, create a starter blockchain, and you're set. That's the easy part - the hard part is convincing anyone to use it - but in a matter of minutes you can have your very own cryptocurrency.
It doesn't take much imagination to think up local possibilities. If your cellphone provider used a cryptocurrency to offer credits for purchasing from a partner network, you'd buy and sell Vodacoins via a trusted exchange, owned and operated by someone you trust and who is carrying the legal can if something goes wrong. Joncoins, not so much (no really! trust me!)
There are already several alternative cryptocurrencies, generally derivatives of Bitcoin in one way or another. Litecoin and Ripple are probably the two most popular, but still vastly less popular than Bitcoin. There are numerous others, and when people start spawning cryptocurrencies named for Internet dog memes, well, let's just say it's probably not going to single-handedly reinvent global commerce.
Bitcoin won't die - the blockchain continues and enthusiasts will stick with it - but it may no longer have the trust it needs to achieve its lofty goals of a global currency revolution.
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