The plight of Mt. Gox shows why a sound regulator is needed for Bitcoin to mature

In a sweet twist of irony, Bitcoin’s biggest exchange house imploded by repeating the sins of the banking system Bitcoin users try to opt-out of.

On Monday, Mark Karpeles, the CEO of the embattled Bitcoin exchange house Mt. Gox announced he was resigning his post from the board of the Bitcoin Foundation — the largest national Bitcoin outreach and education group. Mt. Gox had just run into a second set of problems, blamed on a “technical glitch”, that has prevented users from making withdrawals. This follows a ban put in place this summer which prevented users from withdrawing funds in U.S. dollars.

What happened next? As the*Wall Street Journal reports:

Mt. Gox bitcoins traded at around $191 in midday Monday trading in Tokyo, while the Coindesk index bitcoin traded at around $578.

The “discount at Mt Gox reflects the markets ongoing belief that bankruptcy is a high possibility,” said Mark T. Williams, who teaches finance at Boston University in an email on Friday. “They have a considerable customer base that remains prevented from getting their money out.”

*Bitcoin evangelists argue that the defining lack of a central bank or monetary authority — the true self-regulating free market — makes Bitcoin a safer place to park capital than currencies under the eye of central banks.

But there’s also a compelling argument that what’s happening with Mt. Gox is a classic run on the bank and Mt. Gox is in trouble because it was engaged in fractional reserve lending — reinvesting investor’s deposit.

As David Howden at the libertarian-minded Ludwig Von Mises institute points out, Mt. Gox has become the very same entity that many in the Bitcoin community were trying to get away from:

What may be happening is a good old fashioned bank run. Like all banks, Mt. Gox is operating under a system of fractional reserves, loaning out or otherwise making use of bitcoin deposits entrusted to it. There are many more claims to the bitcoins depositors have with it than are actually in the digital “vault” at Mt. Gox. This is not unlike your bank, which has many more claims to each dollar deposited in it than it has dollars in the vault to honour. If too many people make a withdrawal at the same time, your bank has two options.

Option one is that everyone gets some small percentage of their original deposit. Option two is that only the first small percentage of people who get to the bank first get their whole deposit. Neither option looks very appetizing.

Lest this post be misunderstood, this is not a fundamental problem of bitcoin, but one of fractional-reserve banking. Here we have an example of a purely unregulated currency succumbing to the same problems that have plagued money users for hundreds of years. When banks are allowed to function with fractional reserves, it matters not if the money is state-issued (like dollars) or market-created (like bitcoin), the outcome is the same: bank runs and depositors left with the inevitable losses.

The great irony is that for Bitcoin to mature as an investment vehicle or currency, regulators will need to create sound monetary policy. The average person won’t want to step into the wild west of cryptocurriences if the defining narratives revolve around bank runs and fraud. Manipulation will happen not by central bankers, but by*malevolent actors.

Some anarchist and libertarian members of the Bitcoin community won’t like it, but the best way for the cryptocurrency to mature — and for regulators around the world not to go to war with it — is for the Bitcoin community to work with lawmakers in crafting policy. Granted regulation doesn’t have a perfect track record either, but we can see as well what an extreme laissez faire regulatory environment can bring too.

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