How deep does the Rabbit-Hole Gox?

On January 3, 2009, Satoshi Nakamoto established the Genesis block. That’s a fancy way of saying he “mined” the first Bitcoin.

He didn’t go out to some cave in Madagascar with a pickax and come back with a shiny, precious metal. He ran a hashing algorithm on his computer for a while and stored the results in a ledger. We call that ledger the “blockchain”. It’s public information. The reason it’s public is so that it’s distributed. The reason it’s distributed is because, unlike with US Dollars, if you get on some government official’s bad-side, there’s virtually no risk of your assets being frozen (or stolen).

The blockchain is a pretty revolutionary technology. And after the mysterious Nakamoto releases the Genesis block to the public, crypto enthusiasts take notice. Some of them start “mining” Bitcoin. Some of them do it out of the goodness of their hearts. But a lot of them are probably driven by the reward that gives “mining” its name. When you run this hashing algorithm on blocks of transactions and store the results to the public ledger, you’re rewarded with Bitcoin. At its peak, this reward could amount to more than 250,000 US Dollars.

When the first miners took notice, Bitcoin didn’t have any value. But the miners hoped that, in the future, it would. Within 10 months, they were proven right. In October of 2009, New Liberty Standard set the exchange rate for Bitcoin. These were the early non-shady days of Cryptocurrency. The value was set at the humble price of 1,309.03 BTC to one US Dollar, or about $0.0007. This was not a get-rich-quick scam. New Liberty Standard derived the price from the cost of electricity used by a computer to generate, or “mine”, the currency.

Fast forward another 10 months, and the first Bitcoin sale occurs. Previously dozens of users had bought Bitcoin from one another, but on May 22, 2010, a BitcoinTalk user by the name of Laszlo purchases something with Bitcoin. Specifically, Laszlo busy a pizza off another user for 10,000 BTC (~$200M at Bitcoin’s peak).

A couple of months later, in July, Slashdot picked up the story. The value of Bitcoin rose from $0.008 to $0.08 in 5 days. That’s a 10x increase! That’s the type of growth that gets attention.

And with attention comes scandal. Exactly one week later is when things start to get shady. Mt. Gox, a Tokyo-based company that traded Magic the Gathering playing cards, starts operating a Bitcoin exchange. Demand goes through the roof, and on March 6, 2011, Jed McCaleb sells mtgox.com to Mark Karpeles.

Mark Karpeles is the kind of guy that makes the Wolf of Wall Street seem like a saint. A month before he takes over Mt. Gox, the price of Bitcoin reaches $1. That’s a 125x increase from the price 7 months back, the day of the Slashdot story. It’s a 1,309.03x increase from the original value. You’re not finding that kind of return on Wall Street. You’re also not finding these type of wolves…

When sane people see a rise in price like that, they start to wonder if maybe the asset is inflated. Mark Karpeles doesn’t think that. He bets everything, literally, that the price climb will continue. This might sound pretty risky to you. But with an exchange at his hands, Mark Karpeles can guarantee a price increase. And since a guarantee isn’t really a risk, it’s no surprise Mark Karpeles takes it.

Within a few weeks, he finds himself with some competition. Three other Bitcoin exchanges open, allowing Bitcoin to be purchased for Fiat money. Britcoin trades BTC to GBP, Bitcoin Brazil trades BTC for USD and BRL, and lastly, BitMarket.eu opens Bitcoin up to the Euro.

With Bitcoin now easily convertible to and from almost every major currency, it only takes another two months, until June 1st for the price to increase 10x again. On the same day, Gawker publishes an article about the Silk Road, a website that allowed you to purchase anything from heroin to a hit on your husband. Users could purchase these things in Bitcoin and only in Bitcoin. And the purchases were anonymous.

Predictably, when the public finds out about how easy all of this is, demand for Bitcoin skyrockets. It’s no longer a play-toy for technologists. It has real, tangible value in facilitating narcotics transfer. Everybody who’s anybody wants an easy way to buy recreational, quality drugs through mail order delivery. So the price of Bitcoin climbs to $31 within a week of the publication.

Murders purchased aside, all is not rosy in Bitcoin-land for long. On June 19, 2011, Mt. Gox is hacked. An attacker gains access to the database. Armed with all the usernames and passwords, the attacker sells Bitcoin from random accounts until the price of Bitcoin plummets to $0.01.

This attacker isn’t the sharpest tool in the shed, though. Mt. Gox easily fixes this. The exchange shuts down, reverses the trades, and all is well, at least on Mt. Gox. The price of Bitcoin re-stabilizes. But the attacker uses those same usernames and passwords to hack the wallets of 600-some users. In total, he makes off with about $50k.

As far as financial crimes go, this one is pretty insignificant. The average banker on Wall Street steals more money than this while he’s taking a shit on his lunch break. But it’s a precedent. It shows that a distributed ledger isn’t all pros. It has its cons. And the cons start seeming like they aren’t worth the trade-offs as this sort of activity becomes more and more common, and the values would keep increasing until January 26, 2018 — when $530M was stolen in a single hack.

A few weeks after the first hack, Coinbase / GDAX opens for operations in the US. Bitstamp opens in Luxombourgh not much later. And on October 7, 2011, the world’s second Cryptocurrency is released: Litecoin.

In the following year, Linode will be hacked, resulting in the theft of $150k+ worth of Bitcoin. The Bitcoin codebase is forked for the first time, and investors worry which version of Bitcoin (if any) the miners will run. Lastly, Bitcoin undergoes its first “halving day” — where the reward for mining a block is cut in half. With the reward dropping, investors fear miners will quit, and some entity will become a “51% miner”.

For reference, a 51% miner can control the history of Bitcoin. That means, the miner can say whoever it wants owns however much Bitcoin it wants. So if you own $1M in Bitcoin, the miner can say you don’t — if it wants to. It can say it owns all the Bitcoin in the world if it wants to. You don’t really get a say.

Organizations start attempting to pull this off. After all, Bitcoin is worth about $82M at this point. If that’s not a good incentive, I don’t know what is.

But on March 25, 2013, a critical win happens for Bitcoin that assuages those fears and starts first Bitcoin Bubble. The European Central Bank and the International Monetary Fund bailout Cyprus to the tune of €10B. Among the conditions of the bailout is a hefty levy collected from bank accounts in Cyprus with holdings over the €100K cutoff.

Since Cyprus was — at the time — a popular global tax safe haven, particularly for Russians, panic ensues to get money out of the country in a hurry. As the story goes, some of the billions of Euros held in Cyprus are laundered out by purchasing Bitcoin in Cyprus and selling it to an account in a different country. As far as money laundering goes, this is revolutionary. Since Bitcoin is a new technology, and because of its cyrptographic nature, laundering money has never been so easy and yet so tricky to track down. In ten days time, the value of Bitcoin doubles. In 20, it nearly triples, and the increased trading volume breaks Mt. Gox — the most popular exchange at the time.

And this is where the real mystery of Bitcoin begins.

Is the price of Bitcoin set by its utility to launder money? Or is it almost entirely a fraud? I used to believe that capital flight in China and money laundering (mostly to avoid international sanctions on Russia) was causing most of the price increase in Bitcoin. But the evidence is conclusive that the price rise in 2013 is almost entirely the result of fraud in Mt. Gox.

The capital flight out of Cyprus was just a convenient narrative to get people to fall for the price increases. The real story, as it is often in financial bubbles, is fraud.