How Mt.Gox went down

February 26, 2014: 10:43 AM ET
Trading bitcoins the old-fashioned way
NEW YORK (CNNMoney)

Bitcoin skeptics say the digital currency is doomed. They're wrong. But the failure of Mt.Gox shows the agony of an evolving industry without any government oversight and led by tech entrepreneurs with zero financial experience.

The shutdown of Mt.Gox -- one of the world's largest bitcoin exchanges -- and the potential loss of more than $400 million worth of bitcoins is the result of abysmal mismanagement at the company.

Mt.Gox is blaming a costly computer hack for its current troubles. But in reality, the company was in dire financial straits long before that. Cash flow issues are to blame, as the exchange balanced a tiny revenue stream with a giant burning hole in its pocket.

By its own account, Mt.Gox collected only $380,450 in revenue during most of 2012. But it lost 13 times that the next year, when U.S. government agents seized $5 million from its accounts for allegedly lying on bank documents.

Such a massive loss would cripple any business, but Mt.Gox remained open. It's still unclear how it could pay its customers -- or its bills -- after losing so much money.

Ever since, though, customers noticed Mt.Gox was slow to process transactions. That gave it the aura of a Ponzi scheme. You could join Mt.Gox and give it your money, but cashing out was near impossible.

Things grew worse on Feb. 7, when it halted withdrawals. The company's computer programmers hadn't accounted for a quirk in the way Bitcoin works, allowing cyber attackers to dupe Mt.Gox with a scheme resembling receipt fraud. When Mt.Gox discovered it was under attack, it stopped any investors from pulling their money out of their trading platform.

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By the time trading at Mt.Gox was halted entirely late Monday, the price of a Bitcoin there had dropped significantly, to $130. Meanwhile it was trading for more than four times that on other exchanges.

The Mt.Gox website was back online Wednesday, but only with a statement saying that the exchange had been closed to "protect the site and our users."

CEO Mark Karpeles also posted a statement saying he was still in Japan and working with "different parties" to resolve the exchange's issues.

The fact that Mt.Gox's management potentially lost all of its customers' deposits to theft is nothing short of gross incompetence. The cyberthieves would have needed to trick Mt.Gox repeatedly -- withdrawing money, faking a receipt and demanding yet another withdrawal. Now imagine doing that for a prolonged period -- unnoticed -- to the tune of millions of dollars and emptying the company's accounts.

The lack of transparency is also astounding. A company with millions of dollars is staying silent about what's going on. At most, it offers the occasional cryptic message assuring customers it's "closely monitoring the situation and will react accordingly."

Related: What is Bitcoin?

For now, Mt.Gox customers are left with more questions than answers: Was Mt.Gox really just an insolvent bank with insufficient reserves? Did it use clients' incoming funds to pay out exiting ones? And why the lack of transparency with loyal customers?

U.S. regulators won't be there to help them get their money back. Mt.Gox is based in Tokyo and isn't subject to the strict controls of Wall Street firms. It also isn't insured by the Federal Deposit Insurance Corporation, as most standard American bank accounts are.

The Manhattan U.S. attorney's office declined to comment Wednesday on reports that a subpoena had been issued on Mt. Gox.

Japanese regulators have been reluctant to intervene until now. On Wednesday, Japan's government said it was assessing the situation and would take action if necessary.

U.S. officials like New York State's top financial regulator, Benjamin Lawsky, jumped at the opportunity to say this is exactly why more government regulation is necessary. U.S. Senator Tom Carper, who heads the homeland security committee, called it a lesson for policymakers.

Mark Williams, a former Federal Reserve bank examiner, said Mt.Gox's failure shows the risk inherent in sending your cash to Bitcoin exchanges -- most of which are located abroad in places like Slovenia and Hong Kong. There's little assurance you'll ever get that money back.

"The problems at Mt.Gox -- lack of strong controls and tight regulation -- are systemic to the Bitcoin industry. The reputational damage will spread," Williams said. "What was the largest exchange is now a collapsed tower of toxic sludge."

Related story: Silk Road heist could doom Bitcoin black markets

Sensing the oncoming wave of doubt, several other Bitcoin exchanges and digital wallet providers sought to reassure investors by taking a harder line with Mt.Gox.

"This tragic violation of the trust of users of Mt.Gox was the result of one company's abhorrent actions and does not reflect the resilience or value of Bitcoin and the digital currency industry," the groups said in a statement.

The executives who signed the letter cast Mt.Gox's downfall as the typical industry evolution that weeds out bad actors. Tom Samson is a Bitcoin faithful in Portland, Ore., who sees Mt.Gox's failure as merely a bump in the road.

"I for one am glad to see Mt.Gox finally die. They've been giving Bitcoin a bad name for far too long," he said. "Onwards and upwards."

Did you have money on Mt.Gox? What about on other exchanges? Have you lost faith in Bitcoin -- or are you sticking with it? We want to hear about your experience.

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