Bitcoin Bank Run, Take 2
Enough people were upset with my previous post claiming that Mt. Gox is suffering a bitcoin bank run because it is holding only a fractional bitcoin reserve that it caused me to think twice about the claim.
I could have been wrong, but I doubt it.
Actually, the backlash was strong enough that it made me think that perhaps I was using some common terms in strange ways. I referred to Mt. Gox as a bank, which is a stretch by some definitions, but it definitely stores bitcoin for clients and as such, acts as a custodian.
Maybe it was the term “bank run” that drew ire. Well, I’m pretty sure I know what a bank run is, but I turned to trusty Wikipedia just to be sure.
A bank run (also known as a run on the bank) occurs in a fractional reserve banking system when a large number of customers withdraw their deposits from a financial institution at the same time and either demand cash or transfer those funds into government bonds, precious metals or stones, or a safer institution because they believe that the financial institution is, or might become, insolvent.
Maybe I should have called it “a run on a bank”, but it´s six one way, a half dozen the other. Both terms describe exactly what I meant.
It could have been that what I was calling “fractional reserves” was somehow misplaced. (As I’ve written extensively on fractional-reserve banking, my potential misuse of the term troubled me greatly.) Again, turning to trusty Wikipedia:
Phew, so far so good. That’s exactly what I meant by the term.
So to summarize my claim, I have accused Mt. Gox of holding an insufficient amount of bitcoin in its “vault” to back all the claims to the cryptocurrency that its clients have.
I made this claim based on several basic pieces of economic theory. All of them involved ways that fractional-reserve banks operated back in a time before deposit insurance. Since there is no deposit insurance on bitcoin, Mt. Gox should be operating in a similar way to these banks, but only if it only has fractional reserves.
1. When fractional-reserve banks are faced with more withdrawal requests than they have money in reserve, they must halt withdrawals or face insolvency. This is what happens when a bank chooses to close its doors and not allow you to redeem your deposit. Mt. Gox has halted its redemption requests on-and-off for many months now, and as of February 7 has halted them indefinitely.
2. Before a fractional-reserve bank closes its doors completely, some historical episodes involved using an “option clause” to stymie the redemption requests of its depositors. The option clause, widely used in the Scottish fractional-reserve free banking era, allowed a bank to not honour a depositor’s withdrawal request, though it also obliged the bank to give the depositor an interest payment in lieu of the immediate return of his money. In sum, the bank would convert your deposit (which you could ask for on demand) to a loan (which it would pay back to you at its own discretion) and pay you an interest payment for your troubles.
Prior to shutting its doors this time ‘round, Mt. Gox charged clients a fee to receive their bitcoin quicker than a standard transfer would allow for. In effect, you could get your bitcoin on demand, but you would have to pay for it. Economically, this is just the mirror image of the option clause with the same end result – holders of bitcoin were motivated to not ask for their money, or were enticed to wait longer to receive it, than would otherwise be the case. (The fee to receive your transfer earlier was a hefty 5%, enough to dissuade depositors from asking for their large transactions to be completed quickly.)
3. Finally, fractional-reserve banks which over-issued bank notes typically saw their notes trade at a discount to those banks that did not over-issue. Since an over-issuing bank (i.e., one that operated with fractional reserves, or one with a lower reserve ratio than its competitors) would run a greater risk of illiquidity (or insolvency), customers would only accept notes issues by them at a discount.
As of my writing of this note, bitcoin at Mt. Gox is selling at about a 20% discount to its competitors (e.g., bitstamp and btc-e).
If it exercises an option clause like a fractional-reserve bank, sells its money at a discount like a fractional-reserve bank, and halts redemptions like a fractional-reserve bank, it’s probably a fractional-reserve bank.
So the question becomes, how did Mt. Gox become a fractional-reserve bank?
Many commentators noted that there is not much of a lending market for bitcoin, so as a result Mt. Gox could not be holding fractional reserves. This claim arises because all modern fractional reserve banks operate primarily by loaning out the money deposited in them. This is not the only way that a bank can end up with fractional reserves.
In the 19th century some grain elevators in the United States also held fractional reserves. They sold some of the grain deposited in them, and thus kept only a portion of it on hand for when farmers came around to make a withdrawal. (Incidentally, the practice of fractional-reserve grain storage caused such disruption in the market that it was made illegal – all grain elevators today must operate with a 100% reserve.) Under the gold standard, despite a thin lending market for gold, banks still managed to hold fractional reserves. All they had to do was sell the gold deposited in them for other assets.
All Mt. Gox needs to do in order to qualify as a fractional-reserve bank is not have 100% of the bitcoin in its vault that its clients have claim to.
Some people are keen to jump to the conclusion that Mt. Gox, or its owner Mark Karpeles, has fraudulently absconded with the missing bitcoins. This could be, and since the exchange is not exactly the most transparent financial institution in the world (and that says a lot!), it is not unreasonable. I think there is a better explanation for the missing bitcoins however.
The bitcoin protocol suffers from what is called “transaction malleability”. Long story short, it is possible (though as will see not assured), that a node in the network changes the associated hash in a way that invalidates it. The result is that two recipients can lay claim to the same transaction before it has been verified, or what is the same, that a transfer is paid twice.
Mt. Gox notably suffers from this debilitation, and as such operates in a way that allows some transfers to be sent twice. In effect, this would take bitcoins from its vault while depositors still have claim to them.
Mt. Gox has blamed this on a “design issue” of the bitcoin protocol, and gives this as the reason for the recent cessation of withdrawals. Nothing could be further from the truth, however, and to blame its current troubles on the general bitcoin protocol is disingenuous, if not an outright lie.
Other exchanges work around this feature of the bitcoin protocol, and do not suffer as a result. Mt. Gox is the only exchange, to my knowledge, which has this problem.
So, back to the original question – is Mt. Gox operating with fractional reserves? I think it’s clear that there is a pretty good chance of it. The methods it is employing at the moment mimic those of the fractional-reserve banks that existed before deposit insurance, and it is known to suffer from a technical glitch that exposes it to this problem.
To be clear, this is not a bitcoin issue but is rather a problem with one exchange which stores them.
So I end in the same way that I began several days ago
Ever wonder what a digital bank run looks like? Nearly one million Mt. Gox users are finding out first hand.
(Originally posted at Mises Canada.)