$500 Million Vanishes Into Thin Air: A Trust Crisis for Bitcoin?

$500 Million Vanishes Into Thin Air: A Trust Crisis for Bitcoin?Half a billion dollars (approximately 3.06 billion yuan) has disappeared without a trace

$500 Million Vanishes Into Thin Air: A Trust Crisis for Bitcoin?

Half a billion dollars (approximately 3.06 billion yuan) has disappeared without a trace. Some say it was stolen outright, while others suspect a scam. Many believe the incident is a consequence of loose controls, lax regulation, and a rampant Wild West culture across the globe a culture widely agreed to require a major overhaul.

However, its important to note that this didnt happen in the Bitcoin world. The missing funds are a result of losses incurred by Citigroups Mexican branch. Last week, Citigroup revealed that its Mexican subsidiary had fallen victim to a contract fraud that cost them $400 million, involving a struggling oil services firm.

Bitcoin advocates will seize upon the Citigroup incident as a rebuttal to the argument that digital currencies are inferior to traditional ones. See, they will say, the biggest, most regulated financial institutions in the world can lose this kind of money, and yet everyone was so outraged when Mt.Gox, the biggest Bitcoin exchange at one time, went down due to the loss of $470 million in Bitcoin.

They will point out that the traditional financial system has been rocked by a series of scams over the years from Bernie Madoff to MFGlobal to the Target hacking and yet no one has suggested that we should abandon the dollar as our currency. So why cant Bitcoin be afforded the same level of forgiveness?

Theres certainly a reasonable argument to be made here. However, drawing parallels between Citis losses and Mt.Goxs collapse only underscores the unique nature of digital currencies and the challenges they face.

When traditional financial institutions are caught up in scandals, investigations are launched and calls for tighter regulation human regulation are made. Bitcoin, however, was born out of a distrust of humans and the institutions they build. It exists on the belief that financial security comes from the perfection of technology, from the code that controls an entire payments system, not from the trustworthiness of the humans participating in transactions.

To save their nascent currency, Bitcoin advocates may find themselves forced to embrace those pesky humans auditors, insurance companies, even regulators, all of whom have been anathema to many of Bitcoins strongest supporters.

This sets up a couple of dilemmas:

1. Can human regulation be integrated quickly enough with Bitcoins free and open philosophy to ensure its security?

2. Can Bitcoin become more secure without sacrificing its openness? Its that very openness, Bitcoin proponents argue, that makes it such a cheap, efficient, and innovative financial platform.

As it stands, those questions remain unanswered. Some of the mainstream institutions in the Bitcoin world those that have attracted venture capital and are trying to woo everyday investors and large companies say they can meet the challenge. They are conducting rigorous technical and financial audits of trading websites and establishing safeguards so that even if a disaster like Mt.Gox occurs, Bitcoin holders wont lose their money. Some are even pushing for government regulation.

Were engaging with regulators because we certainly want Bitcoin to become a regulated industry, says Brian Armstrong, co-founder and CEO of Coinbase, a website that allows users to buy, store, and trade Bitcoin and has raised money from some of Silicon Valleys top venture capital firms.

The most obvious route to greater Bitcoin security is self-evident: independent audits of the websites. Mt.Gox, the Bitcoin exchange that was also a storage service, never released any public audits demonstrating that it possessed the funds it claimed to have, nor did it disclose the technical means by which it secured those funds. The websites opacity made it difficult to investigate the losses.

Last week, Bitcoin forums were abuzz with speculation about how all of that money went missing and who has it now. Mt.Gox has said that it had been under attack by hackers for years, exploiting a well-known but obscure vulnerability called transaction malleability, which allowed hackers to manipulate a Bitcoin payment transaction in progress, fooling the exchange into making duplicate payments.

However, due to the lack of verifiable audit trails, many in the Bitcoin world have struggled to buy this hacking story. Other mainstream theories about how Mt.Gox lost $500 million government theft or a cryptographic flaw have also been refuted.

We may never know for sure where the $500 million went. It simply vanished into thin air.

Armstrong says that, to avoid a Mt.Gox-style event at Coinbase, the company plans to hire independent auditors to conduct public examinations of the companys Bitcoin and dollar reserves. The site also recently released a security audit report about its technological processes that showed it does indeed, as it has claimed, keep most of its Bitcoin in cold storage, or on devices that are not connected to the internet.

Beyond that, even more robust measures are being taken to secure Bitcoin. Elliptic, a Bitcoin storage website based in the UK, offers customers optional coin insurance. For 2% of the total value of a customers Bitcoin stored annually, the website will cover losses due to theft or negligence.

Another company, Inscrypto, is working on a decentralized FDIC, akin to the Federal Deposit Insurance Corporation that protects customers checking accounts. Still in development, the system is much more complex than traditional deposit insurance, using derivatives trading to hedge against risks like Bitcoin price fluctuations. How much it will cost, or even if it will work, remains unclear at this stage. Like several other companies in the Bitcoin industry, Inscrypto declined to comment on the topic.

For some Bitcoin advocates, the emergence of these consumer-protection ideas is itself evidence of the digital currencys superiority to its traditional counterparts.

One of the most cherished technological principles underlying Bitcoin is its openness, the ability for anyone anywhere to set up a transaction node on the payment network. Openness means lower barriers to entry; it allows sites with newer, more secure, more creative financial ideas to easily flourish, while those with clumsy, problematic designs like Mt.Gox die off from their own incompetence. It creates a Darwinian race to the top, toward a more secure Bitcoin.

This process will have unfortunate consequences for users in the short term, advocates argue, but eventually, the biggest issues will be ironed out.

The Bitcoin world is often compared to the early days of the internet. A mere 15 years ago, the web was a Wild West, dominated by pornography and illicit transactions, riddled with fraud and danger. Today, the web still contains all of those things, but it also offers you a more respectable place to post pictures of your kids, buy Christmas presents, and engage in secure conversations with your doctor; it allows businesses to make billions of dollars a year without fear of fraud.

Bitcoins history will be largely the same, Armstrong says. It started as a fundamental breakthrough in reducing the cost of payments, but there are a lot of details to work out. Like the early internet, it will take time to build the underlying infrastructure.

Once that happens, he believes, the digital currency will be unstoppable. But only if people dont get so spooked by the thought of $500 million vanishing into the void that they flee Bitcoin forever.