Bitcoin’s problems are much worse than you thought

The bitcoin faithful would like you to believe that the virtual currency’s recent price swings result solely from the crisis at Mt. Gox, a leading bitcoin exchange firm headquartered in Tokyo.

Don’t believe it: The Mt. Gox affair is a symptom, not a cause, of deep-seated problems in the bitcoin system. It’s a sign that bitcoins aren’t ready to serve as anything but pieces in a very risky, speculative game.

Or as Boston University finance expert Mark T. Williams told state regulators in New York last month, “Bitcoin is an experiment that needs to remain in the laboratory until it can meet the basic standards required to become a beneficial transaction currency.”

To recap, Mt. Gox, which at one time was the world’s largest bitcoin exchange, announced last week that it was suspending all bitcoin withdrawals for “technical” reasons. That meant if you had an account, or “wallet,” at Mt. Gox, your money in bitcoins was frozen--you couldn’t transfer them to a bitcoin account elsewhere. In an update Monday, the firm said it would resume withdrawals once the technical issue has been “properly addressed.” But it didn’t offer a time frame.

The Mt. Gox freeze sent bitcoin prices on a dizzying plunge of 13% to 30%, depending on which service you follow for price quotes. On Bitstamp, bitcoins were quoted at $790 just before the Mt. Gox announcement and $619 just after, a fall of more than 20%. As I type these words, the quote is $674. Back in December, bitcoins were quoted as high as $1,200, a price bitcoin fanciers used as evidence that their pet currency was here to stay.

As we’ve written before, bitcoins could be a useful device, in principle, for a variety of financial transactions, including exchanges of funds between traditional currencies, the movement of financial assets from one country to another, and other transactions for which traditional banks charge unreasonably high fees.

But they haven’t reached that stage yet, and the Mt. Gox crisis shows why in several ways. For one thing, any financial instrument that experiences such wide swings in price over a short period is clearly not something you want to use as a transactional tool. If you’re a business with money in, say, Greece, and you want to cash it out as dollars in the U.S., you don’t want to use a device that could cost you 20% of your money if you oversleep by an hour.

For another, any system that can be so rattled by the problems of a single dealer, no matter how important -- and Mt. Gox has a much smaller share of the bitcoin exchange business now than it did in mid-2013 -- has a serious flaw. Yes, the world financial system was seriously rattled in 2008 by the failures of several investment banks in the U.S., but governments worldwide have been working hard to ensure that it doesn’t happen again.

Finally, as the rumors of problems at Mt. Gox surfaced, the price for bitcoins quoted by the firm diverged sharply from that elsewhere in the market -- Mt. Gox had to offer a higher rate to attract customers. In a well-functioning market, that would give traders an arbitrage opportunity -- buy bitcoins in one place and sell them at Mt. Gox for an instant 20% profit. But no rational market offers arbitrage spreads that wide, and of course the roach-motel aspect of the trade is that once you bought in at Mt. Gox, you couldn’t sell out.

Bitcoin doesn’t have the centralized rule-making that could keep another Mt. Gox from blowing up. Some bitcoin fans say that’s a virtue, but it’s not. “Bitcoin is built on a flawed doctrine of self-regulation,” Williams told me by email, “and the cracks are starting to show.”

He calls bitcoins a “highly speculative virtual commodity” that should be regulated by commodities regulators in the U.S. and elsewhere. Ownership is highly concentrated -- by one estimate, fewer than 800 accounts control half of all bitcoins, which gives them enormous influence over the price. Williams said that means that the price is already inflated.

The real problem is the lack of regulation of a business in which most trading is handed by firms located in places such as China, Slovenia and Bulgaria. That’s why many would-be market-makers are urging government regulators in the U.S. to license bitcoin exchange firms.

The Winklevoss twins, who were made famous by their role in the history of Facebook and are hoping to start a bitcoin investment fund, say regulators should impose disclosure and minimum capital requirements, along with other consumer protection rules, on the marketplace.

They know that without these, bitcoins can’t survive. But the more regulation you have, the more bitcoins just look like another conventional currency or investment vehicle, and that cuts against the libertarian streak in much of the bitcoin community.

The Bitcoin Foundation, which functions as an informal overseer of the bitcoin flame but has no real authority, issued a statement Monday acknowledging that Mt. Gox serves as a “good reminder that Bitcoin is still young and experimental.” No kidding. The baby has potential, but it still has a long, long way to go before it can stand on its own two feet, and it’s not at all clear that it will even make it to adolescence.