Bitcoin has been in the news over the last couple of months — and not for good reasons:
MtGox, once the world’s biggest Bitcoin exchange, filed for bankruptcy protection in Japan on Friday, saying it may have lost nearly half a billion dollars worth of the virtual coins due to hacking into its faulty computer system.
For those not familiar, Bitcoin is essentially an online currency that was created by an anonymous individual (or group). There are a set number of Bitcoins in existence and in order to “get” the Bitcoins, your computer software and hardware must “mine” for them. Essentially, Bitcoin mining is the solving of complex math problems that earn fractional parts of a Bitcoin once successfully completed.
Since there are a set number of Bitcoins in existence, some take the position that Bitcoin is a sustainable alternative currency that can be used to send funds to individuals anonymously, instantly, and for less than a typical bank wire transfer or PayPal transaction, for example. There are numerous exchanges and online “Bitcoin wallets” that can store Bitcoins for individuals for eventual transfer or sale. MtGox was one of these Bitcoin exchanges. However, things went awry.
MtGox was essentially hacked and the hackers were able to duplicate transactions before they settled. This means that if an account had one Bitcoin in it, the hackers could replicate or get the transaction to duplicate or otherwise re-send the Bitcoin — and thus transfer two or more Bitcoin instead of just the one that the transaction was supposed to be for. This is called “transaction malleability.”
Transaction malleability basically allows small changes to take place in legitimate transactions without invalidating them and without having to access private keys. In Bitcoin, this means users can change the unsigned transaction ID accompanying each transaction – during a very short window and under limited conditions – but in a way that can add confusion.
This means accounts were drained or online exchanges lost their own Bitcoins. MtGox suffered both.
Strangely, a report came out this week that MtGox “found” over 200,000 Bitcoins that had been taken offline and stored off of their servers and, therefore, were not lost or stolen by hackers:
The bankrupt Japanese Bitcoin exchange MtGox has declared in its filing that it has found over 200,000 lost bitcoins valued at over $116 million dollars. MtGox (previously the worlds largest Bitcoin exchange) has been in bankruptcy proceedings in the Japanese courts since a major hack in which nearly 850,000 bitcoins were stolen by hackers. Nasty. The coins apparently showed up in an old bitcoin wallet format which MtGox CEO said “it thought no longer contained any Bitcoins”. You can see the disclosure here . This brings the lost Bitcoins to around 650,000 which is a significant improvement – though still a very painful compromise indeed.
Gee, thanks guys. Who runs this thing, anyway?
People are going to have different opinions on this MtGox debacle. Those who endorse Bitcoin will likely point out the fact that the failure was with MtGox, not with Bitcoin itself. On the other hand, people critical of Bitcoin will likely point to this vulnerability as another reason not to trust the fledgling cryptocurrency.
I have a somewhat different take on this incident.
MtGox is just another illustration of the problems with counterparty risk.
There is an old saying that a guarantee is only as good as the person giving it. This was a problem we saw in 2008 with AIG, who was unable to cover the cost of the insurance for credit default swaps that it wrote against mortgages defaulting for CDOs when everything went sour. While MtGox claims that the underlying issue is with Bitcoin itself, others think that the MtGox software contained the vulnerability.
Regardless, MtGox did not have the assets to cover the liabilities that it owed to its users, particularly after it was hacked and lost 500,000 (or 400,000) Bitcoins. This is unfortunate for those involved, obviously. But at the same time, the root issue of counterparty risk should have been obvious to MtGox users. People need to be aware of counterparty risk because it affects them on a daily basis whether they know it or not — especially when it comes to American banks.
Indeed, counterparty risk is something that the Federal Reserve is concerned about with respect to our banking system. The Fed has done “stress tests” to see if banks are “adequately capitalized” if “stressed” by a financial downturn.
An even bigger example of counterparty risk that nearly every American could experience is with their own bank. Just like MtGox, what if deposits at Chase Bank were compromised? The federal government tried to help stem bank runs during the Great Depression by enacting law creating the FDIC. The FDIC currently guarantees each depositor up to $250,000 and has taken the position that money in each account is the safest place in the world.
The biggest example of counterparty risk is with the so-called “entitlements” that Americans rely on and hope to rely on in the future: Social Security and Medicare. Currently, both of these programs are vastly underfunded. Medicare looks like it will be insolvent by 2026, despite Obamacare “saving” it (haha). All other things being equal, Social Security will be insolvent by 2033 (for retirement benefits), but the disability benefits of Social Security will be insolvent by 2016 — thanks to the rise in disability payments during aftermath of the Great Recession and five straight years of deficits during the Obama Administration.
Americans fund the current Social Security and Medicare schemes, which are overspending on people now due to promises that irresponsible politicians made in the past at the expense of future retirees. Call it a Ponzi Scheme or the failure of a counterparty to deliver on its promises — but when the time comes to deliver, and the government cannot, what will happen to folks who rely on a return of their tax dollars?
I call on our politicians to give people the freedom to manage their own retirement and health insurance through private account options and premium support, as have been proposed in the past. Unless drastic reforms happen, the biggest counterparty failure will come in our lifetimes. Heading that off with these reforms would be a good start.
As always, free markets are better markets.
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This week, the markets will still probably digest Yellen’s testimony and follow-ups by Federal Reserve officials. There is a large auction for Treasuries this week as well. Markets will also be following Putin’s moves in Ukraine as well. Look for initial claims to be reported on Thursday (323,000) and GDP from the 4th Quarter of 2013 (consensus is 2.7%).
Have a great week!