Digital Gold (27 page)

Charlie's lawyer explained the basics. The lawyer had reached Charlie's parents and they were ready to put up their house in Brooklyn as collateral for the $1 million bail. But they had conditions: he had to apologize to them and break up with Courtney. When Charlie resisted the conditions, his lawyer told him that he needed to bite the bullet and do what it took to get out.

Once he was released, with an electronic ankle bracelet on, Charlie found his parents and Courtney in the courthouse hallway. They had never met before and clearly had not been talking. When he asked his parents if Courtney could come home with them, they reiterated that if he wanted to be with Courtney they would rescind the bail and he would go back to jail. He privately told Courtney, who was weeping, that he would try to figure something out and call her later. Outside, he climbed into his parents' black Lexus SUV and headed toward his childhood home.

While Charlie had been sitting in the courthouse, the United States attorney in Manhattan, Preet Bharara, the most powerful prosecutor in the country and the same man who had filed charges against Ross Ulbricht four months earlier, publicly announced that his office had unsealed criminal charges against Charlie and the
Florida man known as BTC King, Robert Faiella. At a press conference, Bharara said:
“If you want to develop a virtual currency or a virtual currency exchange business, knock yourself out. But you have to follow the rules. All of them.”

Charlie's offense was not of the magnitude that usually caused a federal prosecutor to hold a press conference, but Bharara clearly wanted to make a statement that he was taking a close look at virtual currencies.

T
HE DAY AFTER
Charlie's release, and less than a mile from where he'd been in jail, the Winklevoss twins stepped out of a black car in downtown Manhattan to testify at the latest government hearing about Bitcoin. This one was being held in the somewhat rundown offices of New York State's top financial regulator, Benjamin Lawsky, who had subpoenaed all the major Bitcoin companies and investors back in the summer of 2013. Lawsky had previously worked in Bharara's office. The arrest of Charlie and Bharara's press conference, just a day before Lawsky's hearing, looked to many Bitcoiners like a piece of political theater, designed to give Lawsky an excuse for a more vigorous crackdown on the industry.

The hearing itself couldn't help being colored by Charlie's arrest. In addition to the Winklevoss twins, Barry Silbert, who had wanted to invest in Charlie back in 2012, was there to testify, as was Fred Wilson, the respected venture capitalist who had a number of run-ins with Charlie over the years. The only panelist with no tie to Charlie was Jeremy Liew, the California-based venture capitalist who had put money into Bobby Lee and BTC China.

The people who had been invited to appear on the panel showed that since the Senate hearing three months earlier, the center of influence within the Bitcoin community had shifted toward Silicon
Valley and away from the Bitcoin Foundation that Charlie had helped create.

When Lawsky, in his first round of questions, asked about Charlie's arrest, none of the panelists came to Charlie's defense. The Winklevoss twins had released a statement the previous day suggesting that they had been betrayed by Charlie's behavior. Both Wilson and Liew emphasized that Charlie was part of an early Bitcoin community, in which the seeming anonymity of the technology was the most attractive quality.

“It turns out that the market of radical libertarians is not very big,” Liew said in his Australian accent.

The diminishing interest in anonymity and central banks did not mean that the panelists had modest ambitions for Bitcoin. They talked about how this new form of money—and the ledger on which it ran—could allow for new kinds of stock exchanges and other things that hadn't even been thought of yet.

“When you are offering free, radically reduced transactions costs, and when you are offering the ability for programmable money that can put a lot of additional functionality on money, then you are talking about a market size of everybody in the world,” Liew said.

All the panelists compared Bitcoin in its current form to the Internet in 1992 or 1993, before the first web browser. Back then, there had been lots of excitement in a small circle of technologists about what the Internet protocol could do, but the programs and infrastructure did not yet exist to make it accessible to ordinary people. It had, at the time, been dominated by fringe communities willing to try out untested technology. In 2014, similarly, the Bitcoin protocol wasn't being used in any particularly compelling way, but that didn't mean it wouldn't be in the future once people discovered customer-friendly ways to harness it.

“We are at the beginning of an exciting time, not just for investors but for all of society,” Wilson said.

As the hearing went on, it became increasingly clear that Lawsky and the two deputies who were helping him ask questions were eager to work with, rather than against, their panelists.

“A lot of people initially react to something new like this with immediate skepticism. All of us should resist being overtaken by that urge,” Lawsky said. “We want to make sure we don't clip the wings of a fledgling technology before it ever gets off the ground. We want to make certain that New York remains a hub for innovation.”

Lawsky was a boyish figure with big, attention-grabbing ambitions. In late 2013 he had announced his plans to create what he called a BitLicense for virtual-currency companies. At the hearing he appeared less the hard-edged interrogator and more the slightly nerdy kid trying to get in with the cool tech kids. If nothing else, it was evident that he thought this was an interesting enough technology that he did not want New York to be left out as it developed.

“We need to think internally about how we can be a more modern digital regulator,” he said. “It's not simply what our rules are, it's also who we employ, how quickly we act. There's a lot to do.”

W
HILE THE
B
ITCOIN
community seemed to have made significant headway with regulators, it was having less success with the banks, particularly after Charlie's arrest.

“Not good” was the simple message that Patrick Murck got, in an e-mail, on the day that Charlie's arrest was announced, from a contact at Wells Fargo who had been eager for the bank to work with virtual-currency companies.

Charlie resigned from his position as vice chairman of the Bitcoin Foundation on the same day as the hearing in New York, but that didn't help. Another executive at Wells Fargo let Pete Briger
know that the bank would not be able to move forward with the joint project with Fortress.

Even before Charlie's arrest, there had been indications that the openness that the banks had exhibited toward Bitcoin, after the Senate hearing in 2013, was now coming to a close. Aside from the reputational risks of Bitcoin, the main hurdle that most banks came up against, internally, was concern about money laundering. Regulators expected banks to keep track of the source and destination of all transactions going in and out, to ensure that the banks were not doing business with terrorists and mobsters. This was generally not hard because banks around the world were forced to keep records on all accounts and all transactions. But banks had faced billions of dollars in fines in 2013 for not adequately monitoring transactions coming from countries like Iran that faced economic sanctions. Many bank compliance officers determined that it would be all but impossible to know where money flowing into Bitcoin companies was ending up. Customers at a Bitcoin exchange could convert their dollars into virtual currency and then transfer the virtual currency to an unmarked address.

Jamie Dimon, the chief executive of the nation's largest bank, JPMorgan Chase, had
told CNBC in late January that he was extremely skeptical that Bitcoin would ever amount to anything real. Dimon said that once Bitcoin companies had to follow the same rules as banks, when it comes to money laundering and compliance, “that will probably be the end of them.”

Barry Silbert knew Dimon personally. When he saw Dimon's comments about Bitcoin, he quickly e-mailed Dimon a link to the pro-Bitcoin essay that Marc Andreessen had written in the
New York Times
. A few days later, Dimon called Silbert. Dimon had clearly read Andreessen's essay and sympathized with the view that virtual currencies could provide some opportunity for people outside the United States who didn't have access to good banks.

But Dimon responded that the potential of Bitcoin was not going to be enough to convince government officials to allow a competing currency to exist. Dimon knew what it was like to work in an industry that came under government supervision. Once Bitcoin came under similar regulation, it would require all the same fees and rules that bothered people in the traditional financial system. He didn't dismiss Barry's arguments, though, and invited him to come in and present Bitcoin to some of JPMorgan Chase's executives.

Dimon's perspective was representative of a broader shift in the banking industry's mind-set since the financial crisis. Before the mortgage meltdown had nearly brought down the American economy, Wall Street had hired some of the best young minds in the world and tasked them with finding innovative ways to make money. When many of those clever innovations ended up contributing to the economic collapse, the banks that survived were made keenly aware of how financial experimentation could go awry. What's more, regulators put in place a raft of new rules that forced banks to think twice before taking unnecessary risks. Just as important, government officials were forcing banks to pay billions of dollars in fines for past infractions. Few banks paid as high a monetary price as JPMorgan.

By the time Dimon and Silbert talked, the most important characteristic of any new business for JPMorgan was not how much money it would make, but how it would sit with regulators. JPMorgan had gone further than most in pulling back from potentially risky activity. During 2013 it had stopped working with remittance companies, check cashers, and even student-loan providers, not because it had to, but because it didn't want the headache. Other banks were taking similar, if less aggressive, steps.

As the comments at Lawsky's hearing suggested, this was nearly the opposite of the attitude in Silicon Valley, which had
not been implicated in the financial crisis. The tech industry was increasingly confident about its own ability to change the world, emboldened by the success of companies like Apple, Google, and Facebook. Some of the most popular tech companies were ones such as Airbnb and Uber that openly challenged cumbersome regulations like those imposed on hotels and taxis. In the financial networks that Bitcoin was hoping to challenge, tech investors like Fred Wilson saw just another set of regulations that could be disrupted to create a more efficient market. If anything, the financial industry seemed even more open to disruption because the incumbent businesses were so afraid of breaking the rules.

Wences, who had been working at the intersection of technology and finance for two decades, acknowledged that for most of his career the center of power and wealth in the United States, and perhaps even the world, had been the financial industry and, specifically, New York. But he was outspoken in his belief that this was about to change.

“It's likely that the next twenty or thirty years are going to be the same for Silicon Valley,” he liked to say. “In no other area are we going to see the passing of the baton so clearly as with Bitcoin.”

The only problem for the Silicon Valley disrupters was that they still relied on banks to hold the dollars they used to pay their employees—and, in the case of Bitcoin companies, the dollars they received from customers to pay for the virtual currency.

Wences Casares had always used JPMorgan Chase as the bank for his previous startups—he had maintained an allegiance to the bank after it had given his first startup an account back in the 1990s. Now, though, when Wences applied to JPMorgan to open an account for his new company, Xapo, he was, for the first time, turned down. He found another bank that initially opened a corporate account for Xapo, but then shut it down right before Wences received a $10 million check from his new investors, the
venture-capital firm Benchmark. Wences was in the unusual position of having an enormous check and no one willing to accept it. He was eventually saved by Silicon Valley Bank, the same bank that was holding money for Coinbase and the only bank showing any willingness to work with Bitcoin companies.

In the long run, though, Wences assured everyone he knew that the cautiousness of the banks would matter less and less. At an event hosted by JPMorgan in the Valley, to discuss Bitcoin, Wences was dismissive when the topic of Jamie Dimon came up:

“I think whatever Jamie does or doesn't do will be as relevant as what the postmaster general did or didn't do about e-mail.”

February 2014

M
ark Karpeles was spending many of his days in early 2014 in a space on the ground floor of the Tokyo office building that housed Mt. Gox. Mark was turning the space into what he called the Bitcoin Café, a real-world showcase for Bitcoin in Tokyo—with a register that would be powered by a point-of-sale system that Mark had been designing. Mark was spending his time working out the details of the café, down to the programmable LED lighting on the ceiling and the recipes for the pastries that would be served. The café was almost ready to open, with wine on the shelves and light blue Bitcoin Café mugs sitting next to the register.

As he puttered around the café, Mark did not look like a man responsible for a financial company that was in the throes of an existential crisis. For most of January, the price of a Bitcoin on Mt. Gox had been almost $100 higher than on any other exchange. This was a result of the continued difficulty that Mt. Gox was having in transferring withdrawals to customers outside Japan. Mark blamed this on American banks, which refused to accept
wire transfers from his Japanese bank. For all the people with dollars stuck at Mt. Gox it seemed that the only way to get money out was by using the dollars trapped in the exchange to buy Bitcoins and then transferring the Bitcoins out of Mt. Gox. The pressure of all these people trying to buy Bitcoins on Mt. Gox, with no ability to go elsewhere, allowed sellers on Mt. Gox to charge higher and higher premiums for their coins.

Then, in late January and early February, something even more worrisome started happening that sent the price heading in the other direction. The customers earlier in January had complained about the difficulty of getting dollars out of Mt. Gox, but now a growing number of Mt. Gox customers reported that they had requested withdrawals of Bitcoin and never gotten the coins. A few days after the hearings in New York, Mark put up a formulaic statement on the Mt. Gox website acknowledging the problem: “Please rest assured that this is only affecting a limited number of users and transactions, and that we are working hard on resolving this problem as soon as possible.”

The thirty or so Mt. Gox employees in the company's Tokyo offices knew little more than Mt. Gox customers about what was going wrong. When Mark wasn't working on the café, he was in his office, behind a locked door on the eighth floor, far from the second- and fourth-floor offices where most of his staff was located. There were visible signs that all the stress was wearing on Mark. He was not yet out of his twenties but gray hairs were visible in his big black mane and he was clearly gaining weight. People in the office heard that Mark's Japanese wife had taken his young son and gone to live with family members in Canada, but Mark said nothing about it. Mark rarely interacted with his employees and maintained the same grip on the company's essential accounts that he had back in 2011 when Roger Ver came to help after the first big crisis at the exchange. The alienation from the ordinary
world, which had helped lead Mark to Bitcoin, also made him a terrible person to run a Bitcoin company.

The Mt. Gox employees were as surprised as the exchange's customers when Mark decided, on Friday, February 7, to shut off all withdrawals from Mt. Gox. The panic that this caused only got worse on Monday when Mark provided the first explanation of what was going wrong.
In a statement, Mark explained that the exchange had run up against a flaw in the Bitcoin protocol. The flaw, known as transaction malleability, allowed devious users to alter the codes that identified transactions in a way that made it impossible to tell if a transaction had gone through. Users in the know could request a withdrawal, change the code, and then request the same withdrawal again. Mark, in his statement, said this was not just a problem for Mt. Gox, but an issue with the Bitcoin software, which should have been fixed earlier.

The statement immediately sent the price of Bitcoin plunging on every exchange around the world—a flaw in the Bitcoin protocol could jeopardize everything. And Mark was correct that transaction codes had been susceptible to alteration for some time. What he didn't mention was that all the other major Bitcoin companies had known about the issue for years and had designed around it, generally by not relying on the transaction code in question. Gavin Andresen, the chief scientist at the foundation that Mark had funded, quickly came out swinging against Mark and said that the issue was not a bug, but a quirk, which others had dealt with easily. Mark came under withering attack from nearly every developer working on the Bitcoin software.

“MtGox tried to blame their issues by throwing Bitcoin under a bus and I am glad there has been a public rebuttal showing up their incompetence,” one programmer on the developer e-mail list wrote.

After Mark publicized the issue, transaction malleability did, in fact, become a point of attack on the Bitcoin network. Bitstamp,
the largest exchange, shut off Bitcoin withdrawals one day after Mt. Gox's announcement. But Bitstamp emphasized that it had lost no money as a result of the issue and, after putting together a quick patch, it was back up by the end of the week. Other exchanges remained open throughout. Mt. Gox, on the other hand, remained closed, creating a growing fear that something bigger was wrong.

W
HEN
M
ARK
K
ARPELES
showed up for work on Friday morning, his umbrella barely protected him from the unfriendly wet snow falling from the sky.
He was wearing a short-sleeved shirt that hugged his round body, and he carried a large frothy coffee drink. Almost all the other exchanges around the world had recovered from the transaction malleability scare, but Mt. Gox showed no signs of allowing customers to again withdraw money. Mark's entrance to the building was blocked by a young man who had flown to Tokyo from London two days earlier to try to get some answers. With a sign in one hand that said, “Mt Gox where is our money,” the protester, a mustachioed programmer named Kolin Burges, placed himself in Mark's way and said, “Please, can I have a chat with you?”

Mark first tried to dodge him, but then stopped reluctantly when the man said, “I came all the way from London to try and get my Bitcoins from you—to find out what's happened.”

“We can't do anything right now,” Mark said, looking both disdainful and scared. He started again toward the door when Kolin asked the key question: “Do you still have everyone's Bitcoins?”

“Can you let me get inside please,” Mark said as he tried to pass Kolin, who was bobbing and weaving to get in his way. “I'm going to call the police,” Mark threatened, before Kolin finally let him pass.

Upstairs in the Mt. Gox offices, the staff didn't know any more than Kolin did about what was going on. They were still operating
the exchange, allowing people to buy and sell Bitcoins with whatever dollars were still in their Mt. Gox accounts and taking in new deposits from daring customers. The price of a Bitcoin on the exchange fell lower and lower as people doubted they would ever be able to get the coins out. On Friday, the price stood at $300, half what it was on Bitstamp. Some people, including Roger Ver, were convinced that Mt. Gox's problems were temporary and jumped at the chance to buy coins on the cheap.

Mark would later say that during this time he was spending his daylight hours at the office and his nights at his apartment, alone with his cat Tibanne, furiously working his way through hundreds of pieces of paper containing the private keys to Mt. Gox's Bitcoin wallets. He had driven around in his car and collected the papers from the three locations in Tokyo where he had stored them (he had kept the keys on paper so they would not be vulnerable to hackers). Once he was back in his apartment with the QR codes—essentially complex bar codes—he began scanning in the private keys one at a time, with his computer's webcam. A combination of fear and sickness slowly overtook him as each one of the wallets he scanned in showed up on his computer screen as empty.

It would be hard for others to verify Mark's narration of what happened during those days because he kept such tight control over all the exchange's accounts. And as time went on, fewer and fewer people believed anything Mark said. But even if he was telling the truth, it was not what he told his employees and customers when he came in to work on Monday morning, ten days after Mt. Gox shut off withdrawals. In a public statement on the Mt. Gox site on Monday, he said, “We have now implemented a solution that should enable withdrawals and mitigate any issues caused by transaction malleability.”

On the narrow Tokyo street outside the office, Kolin Burges maintained his one-man protest. There were still few Japanese
people using Bitcoin, but Kolin did attract a few foreign supporters who showed up as the week went on without any sign of a resolution to the problem. Mark had two security guards advise the staff on how to deal with intimidating encounters. Mark himself started taking taxis to work and leased space in an office tower with better security. On Friday, Tokyo police showed up to remove the protesters.

A few hours after the police left, the Winklevoss twins landed in London for a weekend appearance at Oxford University. When they turned on their phones in the plane, they found a worrisome e-mail from Mark's deputy, Gonzague, with whom they had dealt in the past.

“I would like to talk to you urgently regarding the situation with MtGox,” he wrote. “Would you mind signing this NDA and call me ASAP on my mobile phone.”

Cameron Winklevoss replied that a nondisclosure agreement could be tricky, but he was happy to talk. After being out in London all day, Cameron finally managed to connect with Gonzague by Skype when he got back to his hotel Friday night.

Gonzague got right to the point and explained the staggering extent of the problem: some 650,000 Bitcoins—essentially all the company's customer holdings—were gone, along with 100,000 coins that belonged to the exchange.

Cameron was stunned. Doing the most basic math in his head, he knew that Gonzague was talking about hundreds of millions of dollars worth of Bitcoins.

“How is that possible?” was all Cameron could ask.

Gonzague said that someone had been stealing from the company's online, or hot, wallet by changing the transaction identifiers. When the hot wallet was empty, Mark had unwittingly refilled it with coins from the cold, offline wallets. Gonzague
told Cameron that Mark had continued doing this over and over again, until all the offline wallets were empty. The whole thing had been going on for months, or even years, and Mark apparently never realized it until now.

The explanation struck Cameron as implausible, but it didn't seem worthwhile to argue now. The bigger question was what was going to happen next.

Gonzague sounded oddly upbeat. He explained that Mark had “burned himself” and was agreeing to step aside, making it possible to move the business to Singapore and reincorporate under new owners, with the twins being obvious candidates. Gonzague thought it would be possible to do this without telling anyone what had happened. If the exchange could get an infusion of coins the business could make up the missing money over time, from fees. If this wasn't done, Gonzague said ominously, it could set Bitcoin back years.

It didn't seem like a terribly attractive business proposition to Cameron, but he wanted to hear more—if only to understand how bad this was all going to be for his Bitcoin holdings. He asked Gonzague to send him some sort of concrete plan for what they had in mind.

The next day Gonzague sent the twins a twelve-page document, labeled “Crisis Strategy Draft.” It had been put together for Mark and Gonzague by a small public relations firm run by some Americans living it Tokyo. It was clearly a draft document, with typos and inconsistencies, but it pulled no punches about what had happened:

The reality is that MtGox can go bankrupt at any moment, and certainly deserves to as a company. However, with Bitcoin/crypto just recently gaining acceptance in the public
eye, the likely damage in public perception to this class of technology could put it back 5~10 years, and cause governments to react swiftly and harshly. At the risk of appearing hyperbolic, this could be the end of Bitcoin, at least for most of the public.

After reading through the document, and its four-part plan for closing Mt. Gox temporarily and reopening it under new owners, the twins still couldn't figure out what was being asked of them, other than putting a lot of money into a failing company.

“I understand the larger points you raise, but it is unclear to me what the exact plan of action here is,” Cameron wrote back.

The twins were not the only people to whom Mark and Gonzague were looking for a lifeline. They also sent the Crisis Strategy Draft to Barry Silbert in New York, who had his Bitcoin Investment Trust up and running with tens of thousands of Bitcoins. Essentially everyone told the Mt. Gox team the same thing: there was nothing to do but admit the losses and declare bankruptcy. When Roger Ver met the Mt. Gox team at the Tokyo American Club on Monday morning, he told them that no one in the world had enough Bitcoins to bail them out, except perhaps Satoshi Nakamoto. Mark and Gonzague didn't believe it, and wanted to keep the information in a small circle of people to give them more time to find a savior. After Mark refused to admit the problem in a call with members of the Bitcoin Foundation, Roger angrily called some of the foundation members himself and let them know what was happening.

Once the word spread among the top Bitcoin companies on Monday, they all began preparing for something that had the potential to take down the whole Bitcoin experiment. In a shared Google document, they worked on a joint statement that gave their best argument for why people should not lose hope. Ordinary
Bitcoin users got some indication that something was wrong when Mt. Gox's Twitter account suddenly disappeared on Monday. But Gonzague and Mark continued to hold out hope that someone would come in and bail them out. When Cameron wrote on Monday to ask what was going on, Mark said he was planning to begin talking with a bankruptcy judge on Tuesday. But, he emphasized, “Our current goal is to try to save MtGox before filing for bankruptcy—in which case filing wouldn't be required anymore.”