Saving Bitcoins

Human oversight, transparency and robust infrastructure can make the beleaguered digital currency safe and stable, says Farhad Manjoo.

Nearly half a billion dollars has gone missing, and nobody knows how. Some say there was outright theft. Others suspect fraud. Many blame lax controls, poor oversight and, above all, a reckless, globe-spanning, Wild West culture - a culture that everyone agrees is ripe for wholesale reform.

I’m not talking about Bitcoin. I’m talking about Citigroup, which disclosed recently that its Mexican banking unit lost $400 million in a contracting swindle involving a shaky oil services company.

To backers of Bitcoin, the Citigroup revelation was a convenient rhetorical weapon: Look, the digital currency’s boosters say, if one of the world’s largest and most tightly regulated financial institutions can also lose a boatload of money, why is everyone getting so bent out of shape about the $470 million collapse of Mt. Gox, once the largest Bitcoin exchange?

In the last few years the conventional financial system has lurched from one new fraud to another - from Bernie Madoff to MF Global to the hacking at Target - and yet nobody suggests abandoning dollars as a means of trade. Why aren’t we just as forgiving in our approach to Bitcoin?

It’s a tidy argument. But the comparison between Citigroup’s loss and the fall of Mt. Gox highlights just how unusual and untamable digital currency can be. When scandal engulfs traditional financial institutions like Citigroup, there are investigations and calls for greater oversight - human oversight.

Bitcoin, though, was born of mistrust of humans and their institutions. It rests on the belief that financial safety emerges from the integrity of the technology, a computer code that controls a payment system, rather than the trustworthiness of the humans who participate in it.

To save their nascent currency, Bitcoin’s backers may be forced to alter their philosophy and embrace the same messy humans - auditors, insurers and even regulators - that the currency’s most ardent supporters have long abhorred.

This raises two difficult questions: Can human oversight integrate into Bitcoin’s free-for-all ethos quickly enough to render Bitcoin safe? And, can Bitcoin be made safer without tamping down on the very openness that proponents say makes Bitcoin such a cheap, efficient and innovative financial platform? At the moment, the answers are still very much up in the air.

Some in the more mainstream part of the Bitcoin world - firms that have sought venture capital and are trying to appeal to ordinary investors and large businesses - say they’re up to the challenge. They are working to set up stringent technical and financial audits of trading sites, and to create insurance mechanisms so that holders of Bitcoins won’t be wiped out by catastrophic losses like the one at Mt. Gox. There are even efforts to pursue government oversight.

“We are reaching out to regulators, because we do want Bitcoin to be a regulated industry,” said Brian Armstrong, the co-founder and chief executive of Coinbase, a site that allows people to purchase, store and trade Bitcoins and that has received investments from some of Silicon Valley’s leading venture firms.

He said he had met with state and federal regulators to discuss Bitcoin. “Even if everybody in Bitcoin doesn’t believe in regulation, we think it’s one way to help Bitcoin grow up and have more transactions flow over the network.”

The most straightforward way of improving the safety of Bitcoin is also the most obvious: running independent audits of sites. Mt. Gox, which acted as a Bitcoin exchange site as well as a “wallet” that stored people’s Bitcoins, never once offered a public accounting showing it possessed all the funds it claimed to be storing, nor showing the technical methods it was using to safeguard those funds.

The site’s opacity will make investigating its loss more difficult. Theories about how Mt. Gox really lost all that money, and who has it now, have consumed Bitcoin discussion sites in the recent times. Mt. Gox has said it was hacked over a period of years, apparently through a well-known but minor flaw in Bitcoin known as “transaction malleability.” The flaw allows hackers to alter a Bitcoin payment while it’s in progress, potentially confusing a trading site into issuing a double payment.

But in the absence of an audit trail, many in the Bitcoin world have trouble believing the hacking claim. On the other hand, every other leading theory for how Mt. Gox might have lost a half-billion dollars - whether government theft or cryptographic error - has been debunked, too. It’s possible that we’ll never really know what happened to that half-billion dollars. It has simply vanished.

Armstrong said that to prevent something similar from ever happening at Coinbase, the firm plans to hire independent auditors to conduct a public investigation of both its Bitcoin and dollar holdings. The site also recently published a “security audit” of its technical processes, which showed it did live up to its claim of storing most of its Bitcoin holdings in “cold storage,” meaning on machines that are not connected to the Internet.

Then there are more far-reaching efforts to secure Bitcoin. Elliptic, a British bitcoin storage site, offers optional insurance on your holdings. For a fee of about 2 percent of your coins per year, the site promises to repay you if theft or negligence results in the loss of your funds.

Another firm, Inscrypto, is working on a system similar to the Federal Deposit Insurance Corp., which protects your checking account. The system, which is still a work in progress, is far more complex than traditional deposit insurance, using derivative trades to protect against price swings or other dangers of Bitcoin.

To some supporters of Bitcoin, the rise of these consumer protection ideas is itself proof of the digital currency’s superiority over old-fashioned currency. One of Bitcoin’s most cherished technical tenets is openness, the idea that anyone, anywhere, can set up a trading node on the payment network. Openness lowers barriers to entry; it allows sites with newer, safer, more innovative financial ideas to easily peddle their wares, while rickety concerns like Mt. Gox die under their own incompetence.
In the short run, this dynamic causes terrible consequences for users, but eventually, Bitcoin’s supporters say, the worst problems will get ironed out.

One frequent analogy in the Bitcoin world is to the early days of the Internet and web. Just a decade and a half ago, the web was a place where fraud flourished and danger lurked around every corner. Today the web is still all that, but it is also a place where you post pictures of your children and secure conversations with your doctor.

“The history of Bitcoin is going to be largely the same,” Armstrong said. It starts with a “fundamental breakthrough that lowered the cost of payments, but there will be a lot of details to get right, and like on the early Internet, it will take time for the fundamental infrastructure to get established.” Once that happens, Armstrong says he believes that digital currencies will be unstoppable.