MtGox: Update

Wednesday 05 March 2014

In my last post, I wrote about MtGox’s management possibly going into damage control and setting aside bitcoin cold reserves after discovering they had lost many bitcoins due to the transaction malleability issue. A leaked document, purporting to be MtGox's crisis strategy claimed "cold storage has been wiped out due to a leak in the hot wallet." We rejected the idea that bitcoins in cold storage could have been stolen because it was simply too preposterous, or showed an unbelievable level of incompetence. This position has since been affirmed by numerous bitcoin experts.

In the best case scenario, we thought it was possible that MtGox’s management may have set aside the bitcoins in cold storage and would produce them soon. However, it has now transpired that Mark Karpeles announced that all of MtGox’s cold reserve bitcoins were lost.

Late last week, after filing for bankruptcy, they publicly posted their application for civil rehabilitation, announcing that around 850,000 bitcoins have "disappeared" from MtGox and blaming abuse of a "bug in the bitcoin system".

So the mystery deepens and an even bigger debacle promises to unfold because it is simply not possible for Mark Karpeles to have lost all of MtGox’s cold reserve bitcoins. The alternatives at this point are:

  • MtGox’s cold storage was in fact not a cold storage system but a “topping off” system, which would have made MtGox a really dangerous place to store bitcoins; or
  • Mark Karpeles has hidden important information from the public.

In relation to the first point, Mark Karpeles has previously stated that 98% of customer coins at MtGox were kept in cold storage. For example, under the nickname Magical Tux, Mark made the following statements on in September 2012:

  • “On average 98% of customer bitcoins are held in cold storage, with possible variations on large bitcoin moves (large deposits or customers asking for large withdrawals).”
  • "Offline wallets are generated from an offline system and kept in paper format in three separate locations"

It appears the above statements are untrue if it turns out that MtGox’s cold storage system was not a cold storage system at all. On this front, it should be noted that Mark Karpeles has not explained how MtGox’s cold storage system works.

In relation to point number two, that Mark has hidden information from the public; it does appear that important details have not been explained, such as:

  • The names, number and location of the identified customer accounts that made multiple withdrawals from MtGox’s accounts, how many such accounts were affected and the number of bitcoins withdrawn in such a manner.
  • It is also exceedingly strange that MtGox has not instituted legal proceedings of any kind or made efforts to track down those account holders. Surely, given the amount of bitcoins that have been lost, the first thing MtGox should do is to track down the perpetrators and have them prosecuted to the fullest extent of the law?
  • In relation to the bitcoins that were kept in cold storage, it has not been explained how these bitcoins were transferred out, how often, by whom and where they were transferred to.

Mark’s failure to address these questions leaves a dark cloud hanging over him. Without a proper explanation, he might well be facing further accusations of misappropriating funds.

Bitcoin regulation
A small number of people have made comments to the effect that bitcoin is unregulated and therefore Mark Karpeles cannot be accused of doing anything wrong even if fraud had occurred. This line of thinking is essentially incorrect because normal business rules that apply to all businesses also apply to MtGox. For example, companies are generally prevented from operating whilst insolvent. If MtGox’s cold reserves had in fact been lost or stolen then Mark may have been trading whilst insolvent. How could he not know that the cold storage wallets had been drained if he was authorising the transfers of bitcoins himself?

Furthermore, there are laws governing fraudulent conduct, especially in the context of businesses that deal with the transmission of money. Even though MtGox was operating outside the jurisdiction of the United States, similar laws also apply in Japan. These issues will be dealt with over the next few months. In the meantime, Mr Karpeles has been sued by customers and US Prosecutors have subpoenaed him to preserve and produce certain documents at MtGox. So it appears law enforcement is moving relatively quickly to investigate his conduct.

MtGox's conduct
During the events leading up to the closure of MtGox, at least one act of bad faith occurred when the exchange halted bitcoin and cash withdrawals whilst allowing bitcoin trading to continue. This combination of factors was disastrous for the price of bitcoins on MtGox, which eventually fell to US $135 per bitcoin.

The smoking gun was revealed when the leaked internal MtGox crisis strategy, recommended buying cheap bitcoins on the exchange to erase MtGox’s liabilities towards those customers. If this document is legitimate, it is a clear attempt by MtGox to take advantage of vulnerable customers on the exchange to benefit MtGox. Such conduct is totally unconscionable and would suggest MtGox violated the trust that their customers placed in them.

MtGox has now filed for bankruptcy protection in Japan. Many questions remain unanswered: has this come about through negligence or theft, and if the latter, by whom?

However, there is some light at the end of the tunnel. We might be able to learn about what happened exactly at MtGox because every transaction was recorded on the Blockchain. It will be near impossible for MtGox to invent an alternate story because they will be required to prove everything they did by showing us the trail of transactions on the Blockchain.

Interesting days lie ahead but it might be some time before we have any definitive answers.

By Lloyd Chin


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