Should Mt. Gox Be Bailed Out? What Should Regulators Do in Light of a Major Bitcoin Heist?

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Posted in: Consumer Law

At the end of February 2014, headlines around the globe caused a panic in the Bitcoin and cryptocurrency world. The largest Bitcoin exchange, Mt. Gox, was reporting a loss of nearly 750,000 Bitcoins currency units (referred to as BTCs). In a blog post, Bitcoin blogger Ryan Selkis described an inside report of the Mt. Gox loss, which was reportedly caused by hacks and theft over a 2-year period. The stolen Bitcoins would be worth above $400 million at current prices. A few hours later, Selkis posted a leaked report entitled “Crisis Strategy Draft,” on the digital library site Scribd. It outlines a seemingly foolhardy four-part plan to save Mt. Gox from insolvency. As of now, Mt. Gox, which is incorporated in Japan, has filed for insolvency protection there as well as in the United States.

In this column, I will examine the recent Mt.Gox scandal. Regulators around the world are now rushing to try and deal with this, as unhappy consumers and investors are left without assets, as their Bitcoins have disappeared into thin air. Bitcoins, however, are not regulated in the same way bank deposits are. Instead, they are a fairly unregulated alternative payment method or store of value. Thus consumers had everything to risk when exchanging regular government-backed currency for Bitcoins. I will also explore the different legal avenues that regulators and investors are using to try and protect themselves against future losses, the perils of trying to regulate this new business model, and whether future licensing or government scrutiny will make a difference

The Mt. Gox Meltdown: What Happened

The lights went out on Japan-based Mt. Gox in late February, weeks after a supposed round of hacks, leaving customers unable to access their accounts.

Bitcoins are virtual “currency” and exist solely in electronic form. These coins depend on a network of computers to solve complex mathematical problems in order to validate each transaction. Investors may buy and then deposit their Bitcoins in digital “wallets” at various Bitcoin exchanges. Mt. Gox was the largest as recently as February until it had to stop customer withdrawals after several hacks or security intrusions.

The Mt. Gox hack was epic in scale. It amounted to the disappearance of nearly 7% of the world’s Bitcoins, which were together valued at $473 million. A “bug in the bitcoin software algorithm, which was exploited by one or more persons who hacked the bitcoin network,” may have caused the loss of the Bitcoins, lawyers declared in bankruptcy court papers the loss.

On Monday, February 24, 2014, Mt. Gox’s web presence started vanishing. First, its homepage disappeared. Next, its support page was removed, followed by its press releases. Customers received the message: “The requested page was not found on this server,” when they tried to access their deposits. Users started to panic as they realized that they might never get their Bitcoins back.

And there was no office or bank to rush into, to try and withdraw the coins. They remained on deposit in a virtual vault that had just disappeared from plain view. Although one would assume that some of Mt. Gox’s profits (made through the trading of Bitcoins) were held in normal currency and stashed in bank accounts, it was not clear what recourse anyone had.

It had been a rough February for Mt. Gox. The company froze customer accounts, after the thefts began, citing a technical vulnerability. “A decision was taken to close all transactions for the time being in order to protect the site and our users,” Mt. Gox ultimately reported in a public statement.

What Is the Legal Risk? There Is No Deposit Insurance for Bitcoins

There is no Federal Deposit Insurance Corporation (FDIC) or other national bailout system to back Mt. Gox’s customers’ “deposits.” These were not bank deposits in the traditional sense. Rather, Mt. Gox held these assets for consumers, outside of any legal deposit or insurance scheme. The company had no requirement placed upon it to hold any fraction of Bitcoin deposits as reserves, or to invest any profits made from buying and selling Bitcoins, in trustworthy investments, in order to protect customers in the event of insolvency. All of this was left to the open market, and customers had to put their faith in the exchange. As with many newfangled investments, customers were perhaps too trusting and just saw the rising value of Bitcoins as a way to make a quick profit.

In the event that Bitcoin’s most popular exchange is insolvent, as reports claim, an untold number of customers will have their savings wiped out. Some free marketeers will say that is just the risk of trading in non-legal tender. But others will be asking, “Where is our money, and how can we get it back?”

The total number of Bitcoins tied up in Mt. Gox is unknown, but it looks like millions. The theft ultimately claimed more than 6 percent of the Bitcoins in the world, a nearly impossible loss to make up without some huge effort. Some say that Mt. Gox is therefore too big to fail. According to the leaked “Crisis Strategy Draft,” allowing Mt. Gox to fail might be so damaging to Bitcoin that anyone holding the currency would be better off bailing Mt. Gox out. The report indicated that all the exchange would need for the bailout is 200,000 Bitcoins from investors.

There is a significant group of Bitcoin believers who want the product to succeed for idealistic reasons, so a bailout might happen, but no one seems to be rushing in to invest new Bitcoins in Mt. Gox. Instead, investors are moving their assets elsewhere. That’s not surprising, given that one premise for Bitcoin was freedom from the perceived governmental incompetence that caused the global financial meltdown and resulted in subsequent taxpayer bailouts. Some see currency exchanges like Mt. Gox solely as intermediate business models, which the Bitcoin economy will move beyond. Once people are being paid in Bitcoin and spending money in Bitcoin, there won’t be as much need to buy it with government-issued currency, which is the primary purpose for an exchange. “These large exchanges that are international and global are more important in the early stages of Bitcoin when we need price discovery,” says Jon Matonis, director of the Bitcoin Foundation. “You don’t need them in the long run because in a true Bitcoin economy you’ll have a closed-loop system.”

There has been at least one bailout before. When the Polish exchange Bitomat accidentally erased all its customers’ Bitcoins. Mt. Gox acquired Bitomat and reimbursed its customers.

Mt. Gox and Bankruptcy: Who Has a Right to the Assets That Are Left?

If there is no magic bailout, then Mt. Gox customers are going to fight tooth-and-nail to get money back from the company during its bankruptcy proceedings.

Mt. Gox has filed for bankruptcy protection in a U.S. court to stop U.S. customers from trying to seize cash that it has on deposit in U.S. bank accounts. It has already commenced bankruptcy proceedings in Japan, and those documents are available on the Mt. Gox website (and in fact are the only documents on the webpage as of now). Lawyers who put Mt. Gox into bankruptcy have successfully halted a potential class-action lawsuit from the exchange’s former customers who have sued it in Illinois.

At an early March hearing held in Dallas, Judge Harlin Hale of the U.S. Bankruptcy Court halted a lawsuit after Mt. Gox’s lawyers argued that a challenge in U.S. court would waste money while experts in Japan try to save the exchange. In a potential class-action lawsuit, lawyers are trying to identify U.S. residents who paid a fee to Mt. Gox to buy, sell or trade Bitcoin. In the complaint, one such customer alleges that he wouldn’t have paid Mt. Gox for its services had he known of its “substandard security procedures that left his bitcoins vulnerable to theft.” Lawyers for the customers, who argued in Monday’s court hearing against the automatic halting of their lawsuit, said that Mt. Gox Chief Executive Mark Karpeles has already transferred more than $100 million of Bitcoins out of the banking system. In reaction to that dispute, CoinLab has asked to inspect Mt. Gox’s entire customer database, and is seeking a whopping $75 million in damages.

Lawyers have put Mt. Gox Co. Ltd. into Chapter 15 protection in U.S. Bankruptcy Court in Dallas, where Mt. Gox stores some of its customer data on computer servers. Foreign companies that are reorganizing in their home countries may seek protection under Chapter 15 of the U.S. Bankruptcy Code. Mt. Gox’s request for U.S. recognition of its Japan bankruptcy is set for an April 1 hearing and may ultimately be denied Mt. Gox’s creditors, for example, could raise the point that the nature of Mt. Gox’s core business—facilitating an unregulated virtual currency is against U.S. public policy and sound markets.

Are There Other Legal Remedies?

While there is no white-knight bailout coming to Mr. Gox’s rescue, regulars have turned their gaze to other Bitcoin exchanges and the future of such activity. It’s one thing for one exchange to fail, but regulators fear being blamed for additional failures and losses—and the possible public backlash that may result. There is some fear, although it is speculative, that if multiple exchanges fail, that will disrupt global markets and cause so-called systemic risk and contagion in financial markets.

The question then becomes how governments will monitor transactions to protect Bitcoin owners. Doing so may be even more difficult given that one of the motivations for developing Bitcoin was to avoid any governmental oversight.

Clients may always file lawsuits claiming negligence or breach of contract, but the virtual currency is subject to very little regulatory oversight and no government guarantees so proving a negligence claim may be difficult. So courts and regulators, for now, may stand by and say “Buyer beware.” But at the same time, global regulators are scrambling to deal with the business model moving forward.

As I have noted in a prior column, the U.S. government requires Bitcoin exchanges like Mt. Gox to be licensed as money transmitters under federal anti-money-laundering laws. This federal requirement piggybacks on a state law requirement. State banking regulators license and regulate companies like Western Union and others as money transmitters. Mt. Gox and other exchanges were meant to obtain certain licenses for operating in the U.S. and this would mean that they would be subject to prudential regulation: lighter types of banking laws that would require Bitcoin traders to keep a certain fraction of deposits on hand, and also to safely invest profits and funds in a way that prevents against undue risk. To some extent, state regulation might also lead to some requirements that networks be secure. Other governments—those that have not banned Bitcoin—are likely looking at different models of prudential, or safety-and-soundness regulation—in order to preserve customer funds when held by exchanges.

Another requirement might be require Bitcoin exchanges to pay for some type of deposit or risk insurance. At present, unlike bank accounts in the United States, Bitcoin deposits have no government-backed insurance. Instead, Bitcoin customers have the same avenues of legal redress as anyone who entrusted property to an institution that failed to keep it protected, such as lawsuits for negligence, breach of contract or even fraud. If Mt. Gox has no assets, however, individual claims would fail to recover any funds, absent some sort of deposit insurance or self-insurance scheme. A document circulating online that purports to be a crisis plan for Mt. Gox indicated that to protect customers from a total loss, the government could also require an insurance program along the lines of those provided for bank and brokerage customers. Firms that hold virtual currency on behalf of customers could be required to pay into a fund to be used to reimburse at least part of the loss if another situation like the theft at Mt. Gox were to happen.

New York State’s head banking regulator is exploring licensing requirements for Bitcoin exchanges. The Commodity Futures Trading Commission (CFTC) has considered whether to set rules for the virtual currency since it is a sale of a virtual commodity rather than real legal tender.

In Tokyo, where Mt. Gox is based, Japan’s top government spokesman, Yoshihide Suga has said that agencies including the Financial Services Agency, the Finance Ministry, and the police were collecting information on Bitcoin use in Japan, with a possible goal of regulatory action. One fix mirrors the U.S. approach of licensing—to bring Bitcoin under the purview of Japan’s Payment Services Act, which oversees electronic money, shopping points and escrow transactions.

While Bitcoin has faced relatively little scrutiny in Japan until now, it has invited comparisons to a scandal involving Enten, an electronic currency used by a Tokyo company to defraud investors of billions of yen in the mid-2000s.

Senator Joe Manchin III has offered one approach in a letter sent last week to U.S. regulators. He has asked them “to work together, act quickly, and prohibit this dangerous currency from harming hard-working Americans.” Unfortunately, it is easier to call for a ban on virtual currencies than to actually ban them. Janet L. Yellen, the Chairwoman of the Federal Reserve, has responded to Senator Manchin by stating that that the Fed “simply does not have authority to supervise or regulate Bitcoin in any way.”  This means that Congress would have to act to give regulators such authority.

The Securities and Exchange Commission (SEC) and the CFTC already have in place rules for how commodities exchanges and dealers operate and, perhaps more important, recordkeeping and capital requirements for those who hold the property of others. The idea of recordkeeping allows regulators to follow trails in the event that fraud or theft occurs, and allows regulators to come in to examine books and records routinely.

Needless to say, Bitcoin fans that cherish its anonymity and freedom from governmental oversight will not take kindly to increased regulation. Mt. Gox will not be the end of Bitcoin, but the scandal will push regulators to act. One company’s failings may be the biggest impetus for government action.

Yet the shutdown has not curbed enthusiasm for virtual currency. The price of Bitcoin has continued to rise. So we may still be in the early days of the Bitcoin rush, with some investors on a fool’s errand.

  • Rich Cassidy

    Thanks Anita Ramasastry. Your’s is a very illuminating post. The post does have one frequently expressed description: “These coins depend on a network of computers to solve complex mathematical problems in order to validate each transaction.” I hear this, but I still don’t understand what it means.