Now Bitcoin users know what a cryptocurrency crisis looks like—up close and personal. 

Early Tuesday morning, troubled Bitcoin exchange Mt. Gox abruptly halted trading altogether, following months of increasingly lengthy delays in processing withdrawals for users cashing out bitcoins they stored at the exchange. The precipitating event: A document alleging that Tokyo-based Mt. Gox has suffered an enormous and extended bitcoin theft—one amounting to 744,000 bitcoins, or about $380 million, over the past two years—that rendered the exchange insolvent, or nearly so.

That leaked document—apparently a crisis-management plan offered to Mt. Gox's board—made the rounds after Bitcoin entrepreneur Ryan Selkis released on his blog yesterday. If the document is genuine and news of the theft is true, it would mean that roughly six percent of all Bitcoin in circulation have been stolen.

The bitcoin promptly plummeted against the dollar, falling 23% to below $440 Monday night before rallying to around $520, where it remains at other Bitcoin exchanges as of publication. At Mt. Gox itself, the price of bitcoin dropped below $150 before the exchange suspended trading, presumably reflecting a stampede by exchange customers anxious to cash out their accounts at any price.

Mt. Gox issued a brief and uninformative statement on its website:

In light of recent news reports and the potential repercussions on MtGox's operations and the market, a decision was taken to close all transactions for the time being in order to protect the site and our users. We will be closely monitoring the situation and will react accordingly.

Welcome To The Brink, Bitcoin

All that sets the stage for the first real financial crisis in Bitcoin history—one likely to unfold without government intervention or shock absorbers like deposit insurance that helped buffer more traditional meltdowns, such as the 2008 financial collapse that triggered the Great Recession.

First, though, a few caveats. At the moment, panic over the still-unconfirmed Mt. Gox allegations appears to be limited. And even if the worst were to come to pass—say, should Mt. Gox collapse completely and wipe out its depositors—the stakes for the world at large remain quite limited. Bitcoin, which at heart is a sort of digital cash, features nothing analogous to the baroque web of debt, derivatives and other opaque financial securities that contributed so heavily to the 2008 collapse. 

The real risk to Bitcoin, though, lies in the degree to which the failings of Mt. Gox come to be seen as shortcomings in the largely unregulated cryptocurrency system itself. Bitcoin proponents insist that Mt. Gox's problems are isolated and due to its own poor management. But other exchanges also operate with no third-party oversight and varying degrees of transparency, which may not quell user concerns about the cryptocurrency's stability and reliability—particularly in light of a rash of other recent Bitcoin thefts and scams.

A Run On The Bitcoin Bank

Consider for a moment the uncanny way Mt. Gox's situation parallels that of ordinary banks in the runup to financial crises. First, there's the bank run.

When depositors queue up to withdraw more money than a bank actually has on hand, they can drive it out of business. Federal deposit insurance is designed to prevent runs at traditional U.S. banks, but of course no such protection extends to Bitcoin users. Prior to deposit insurance, step one in the bank-run playbook was to delay withdrawals by any means possible. 

Complaints about Mt. Gox's slowness to release its depositors' funds have mounted for months—ever since the U.S. Department of Homeland Security seized Mt. Gox accounts holding $5 million in May and June of 2013 on suspicion that the exchange was operating an "unlicensed money transmitting business." At various times, Mt. Gox claimed the delays were due to technical issues, although outsiders suspected the exchange was simply having trouble working with traditional banks.

Then earlier this month, the exchange abruptly suspended all withdrawals, blaming its problems on an "inherent flaw in Bitcoin" called transaction malleability. That particular issue, it turned out, was apparently well-known, didn't affect the underlying security of transactions and hadn't seemed to bother any other major exchange.

If Mt. Gox is indeed insolvent, those delays start to make a lot more sense.

Just ask Richard Weston, organizer of the DC Bitcoin Users Group and the man who sold me my first bitcoin. When I spoke to Weston in October, he strongly recommended I trust Mt. Gox with my exchanges. Now he’s lost his trust in it completely, and he’s glad I didn’t take his advice. 

“For me, it started when I was trying to get my cash out of Mt. Gox a few months ago,” he said. “Basically, U.S. customers could not do cash withdrawals because banks refused to deal with Mt. Gox, though Mt. Gox wouldn’t come out and say that. Instead they would send canned response after canned response about a delay in withdrawal time.”

Eventually, Weston had to remove his Mt. Gox money as bitcoins and sell them for cash for a loss on other exchanges. Today he keeps his bitcoins in a Blockchain wallet. 

Mt. Gox, Too Big To Fail

The leaked (and unverified) "Situation Crisis Strategy Draft" document argues that Mt. Gox is simply too important to the Bitcoin ecosystem to collapse:

The reality is that MtGox can go bankrupt at any moment, and certainly deserves to as a company. However, with Bitcoin/crypto just recently gaining acceptance in the public eye, the likely damage in public perception to this class of technology could put it back 5~10 years, and cause governments to react swiftly and harshly. At the risk of appearing hyperbolic, this could be the end of Bitcoin, at least for most of the public.

[...]

The likely consequences will be larger than this localized financial damage, and we believe that the benefits of keeping MtGox stable and running outweigh the risks. This isn’t about saving MtGox anymore.

Translation: Mt. Gox is too big to fail. We've heard that line of argument somewhere before. Outside Mt. Gox, however, it may not be widely shared. Jerry Brito, senior research fellow at the Mercatus Center at George Mason University and director of its Technology Policy Program, says that a Mt. Gox collapse would actually benefit the Bitcoin community.

"In the long term, this is good for Bitcoin," he told ReadWrite in an interview. "It’s good that an unprofessional exchange will exit and leave a space for serious players like Coinbase and Circle to come in and provide serious service to consumers.”

Dear Bitcoin: Please Bail Us Out

Which leads us directly to the Bitcoin Bailout, otherwise known as part one in the plan to keep Mt. Gox afloat outlined in that (still unverified) crisis-management document:

The stakeholders of MtGox are not the owners, but everyone in Bitcoin. This is sad but the reality.

The current situation will negatively affect everyone who owns or operates in Bitcoin. We will need to inject fresh coins inside the system in order to establish a basis to eventually clear the books by running the exchange (perhaps 200,000 coins). The costs of not doing so are incalculable at this stage.

The document calls for a new company—simply dubbed "Gox"—to raise bitcoin funds from unspecified "partners" via donations and in exchange for equity. It's not exactly clear who would want to participate in the recapitalization of the exchange; the plan is similarly silent on what recapitalization would do for Mt. Gox's current customers, beyond a vague reference to preventing a "bank run from customers" by—guess what?—limiting withdrawals.

Obviously, there's no government help in the offing, unless you count the banking regulators who want to use Mt. Gox's problems to push for greater Bitcoin oversight. 

So far, nobody has been able to authenticate the veracity of the leaked document, and Mt. Gox executives certainly aren’t speaking up. So it’s entirely possible that this strategy was a trial balloon, a failed pitch from outside consultants, or something else entirely—even an outright fake.

Collateral Damage

Financial disasters are essentially crises of confidence—times when people fear that the banks and other institutions holding their money won't give it back when they ask for it. The big question for Bitcoin is whether Mt. Gox's problems are specific and isolated, or whether they herald a broader erosion of trust in the cryptocurrency.

Sure, the bitcoin may have stabilized quickly following last night's rumor-revelations, but it could easily start swinging wildly again when the next shoe—assuming there is one, as seems likely—drops. Perhaps more important, that current price stability is a decent indication that current Bitcoin users remain confident, but it tells us very little about the view of the outside world.

In order to work as a mainstream means of exchange, Bitcoin needs to keep establishing stronger links with the real world and building confidence in the cryptocurrency among traditional financial institutions. Bankers, however, are often conservative, and wouldn't be wrong to view Bitcoin as a threat to some of their current business models. And so they may be less sanguine about Mt. Gox's woes than Bitcoin's true believers.

“Our biggest obstacle is the bank community,” Weston, the Washington, D.C., Bitcoin proponent told me. Federal money-laundering charges against a former Bitcoin CEO didn't help; now an alleged Bitcoin theft at Mt. Gox makes virtual currencies that much more suspect. “Why, as a banker, would I support these?" he asked. "Because from [their] perspective it looks like a scam.”

Now, Weston said, we may be back at square one.

“The lesson learned is that Bitcoin is not for everybody,” he said. “It really is a niche for people who are computer savvy and feel comfortable handling and storing their own bitcoins. That's where we are right now because it's hard to trust any exchange after what happened with Mt. Gox.”

Hindenburg image courtesy of Wikimedia Commons