Wednesday, February 19, 2014

A Bitcoin Insolvency?

I was interviewed yesterday by Wired Magazine for an article that appears on their website about a potential insolvency situation at Mt. Gox, one of the larger "Bitcoin exchanges".   So I thought I would write a little about that situation.

For those who don't know what bitcoin is, perhaps because they are overwhelmed by the millions of articles written about it in the past year, it is considered to be "the first decentralized digital currency" (there are many apparently).  The home page of the Bitcoin foundation calls it "an innovative payment network and a new kind of money".    There is a very clear video on that page that explains it.  

Its appeal is based on (1) it can be privately created - anyone can download the free software and become a "bitcoin miner" and create one or more bitcoins just by running that application, and thus it does not depend on government fiat, which appeals to the libertarian philosophy that imbues much of the Internet; (2) the software is ingeniously designed to become harder and harder to run, thus limiting the amount of bitcoins that can be generated, making it -- aspirationally at least -- superior as a store of value to fiat currencies; and (3) transacting in bitcoin does not require payment intermediaries like banks, and thus is harder, although not impossible, for law enforcement agencies to trace it, which appeals to a certain class of users.  A secondary kind of appeal exists in the speculative fervor that has arisen around bitcoins, not unlike tulips or Pokemon cards. 

As best I can figure, although the creators of bitcoin envisioned that it would operate outside of the conventional system of payment intermediaries like banks, exchanges like Mt. Gox have arisen so that persons who do not choose to become bitcoin miners themselves can nonetheless acquire bitcoins to trade against other currencies in the hope of a speculative profit.   

When I use the term "exchange" to describe Mt. Gox, I am not making a legal characterization but simply using the terminology of the article.  Mt. Gox's website says it "is not a currency exchange."  Looking at its website and reading some articles about it, it appears to be a  Japanese corporation, a "Kabushiki kaisha", denominated by a "K.K." after its name."  I have no idea whether it is an "exchange" in some legal sense under Japanese law or carries any other special status under Japanese law.  It would not seem to be an "exchange" under the Securities Exchange Act of 1934, as bitcoins do not seem to come close to qualifying as "securities" given there is no underlying company to which they relate.

Whether bitcoin is even a "currency" in a meaningful sense strikes me as doubtful, at least at present.  A currency functions as a means of payment and a store of value, and in some theories a unit of measurement.  As bitcoin is accepted as a means of payment by in an infinitesimal percentage of private establishments, and not at all by any public sector actors AFAIK, at the present time, it does not seem to satisfy the first condition.  It resembles less a national currency and more the kind of token that private sector actors sometimes create for loyalty purposes, like frequent flyer miles or S&H Green Stamps, each of which is (or was) accepted by a small group of private vendors in exchange for goods or services.   There is, I suppose, an analogy to precious metals, although those are no longer used as a means of payment either.

It's not clear whether, or how, Mt. Gox has become insolvent.  The article indicates that there may be a flaw in its customer-facing software that enables customers to make duplicate withdrawals from their account, and given the digital environment, it is not hard to see how that could be exploited by an automated program.  As I read the Mt. Gox website, deposits and withdrawals appear to be in real currencies, not bitcoins.   So I assume customers wise to the flaw are withdrawing non-bitcoin currencies. 

The next question is whether that money come from Mt. Gox or other customers?   That seems to depend on the mechanics of how Mt. Gox takes and holds customer money and processes those withdrawals, which is unclear from the article and the Mt. Gox website.  If all customer deposits and withdrawals go into and come out of the same account, then, if the account is compromised, every customer could potentially be screwed.  It is somewhat like the MF Global meltdown, although the commingling may not be of house funds and customer funds, as in MF Global, as much as all customers' funds, the innocent and the guilty, together.  Absent a strong protocol governing disbursements, there may be a loss on the part of customers, which could give rise to claims against the operator, Mt. Gox, for negligence or what have you, and conceivably make it insolvent.

A company should not set up its accounts like that, letting customers access an account that maintains a balance of any kind.  Rather, it is customary for businesses to set up  "zero-balance" accounts for the purpose of customer refunds and things like that.  Such accounts begin and end the day with no balance. Instead, the bulk of funds is kept in a central "concentration account" and the finance department transfers money out of the concentration account at the end of the day to cover demands made on the zero balance account and other accounts.  Essentially it is a "hub and spoke" system for cash management.  I have no idea how Mt. Gox set up their accounts, how professionally or amateurishly, but the norm for a professionally run business in the US would be to have some version of the hub-and-spoke cash management system.

If improper withdrawals are being made in bitcoin, then there is still some kind of theft or conversion going on, just as if someone stole your gold that was being held in a vault, and the same issue arises of how the shortfall in all the assets Mt. Gox has, versus the amounts stated to be owed to customers, will be addressed.  That would require some knowledge of Japanese insolvency law, which, alas I do not possess.

A U.S. bankruptcy may be unlikely, unless Mt. Gox has some US property to enable it to become a debtor under the Bankruptcy Code. Given the somewhat shady nature of many bitcoin dealings, I would assume the owners/operators tried to limit their U.S. presence.   One could envision, if a Japanese insolvency proceeding were to arise, a chapter 15 in the U.S. as there might be a number of U.S. customers, Idk, and the foreign representative might want to stay suits in various countries outside Japan and force everyone into a single forum, but I have no experience with the Japanese insolvency regime and am just going off of what has happened in other multinational bankruptcies in recent years.  In any case, a bankruptcy filing in any nation would probably draw a great deal more scrutiny over the operation than the owners, operators or many customers would find desirable.