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Bitcoin’s fatal flaws

How would you react if your currency of choice lost 20 per cent of its value in the span of a few hours?

It happened to bitcoin today after a Japanese exchange suddenly halted withdrawals of the popular virtual currency.

Protecting the unprotected

The MtGox exchange, one of the world’s largest bitcoin traders, explained in a statement that hitting the brakes was the best way to protect everyone’s interests. The exchange had been wrestling with significant delays in converting from conventional currencies to bitcoin, and an increase in the volume of withdrawal requests made a bad situation worse.

“To understand the issue thoroughly, the system needs to be in a static state,” the statement said. “In order for our team to resolve the withdrawal issue it is necessary for a temporarily pause on all withdrawal requests to obtain a clear technical view of the current processes.”

News of the MtGox move sparked a rapid bitcoin selloff, pushing its value down to US$690 before recovering to $750 by press time. The currency, which has traded as high as $1,200 in recent months amid growing speculation that it could evolve into a viable financial instrument, has suffered a number of recent setbacks that suggest bitcoin’s reality is falling far short of its hype:

  • When a Chinese exchange suddenly shut its doors in November, just over $4 million in customers’ bitcoins disappeared in the process.

  • Quebec’s Autorité des marchés financiers released a strongly worded statement Wednesday warning consumers against using bitcoin. The AMF said bitcoin transactions aren’t protected by traditional deposit insurance, and could leave consumers exposed in the event of fraud.

  • The European Union banking watchdog had similar reservations, and a French Central Bank report warned, “The system can collapse at any moment if investors want to unwind their positions but find themselves holding portfolios that have become illiquid.”

  • Canada’s Finance Department recently said bitcoin is not traditional legal tender, and while it confirmed it will continue to monitor the currency, it has no current plans to review its existing policy.

  • Apple removed the BlockChain app from its app store. The app allowed iPhone users to store and spend bitcoins on their mobile devices, and it was one of the last bitcoin-capable titles available for the iOS platform. Apple is reportedly building its own online payment solution, which would compete directly with bitcoin.

  • Russia’s Central Bank banned Russian citizens and companies from using it, claiming it made it too easy for criminals and terrorists to secretly launder money.

The growing cascade of failures, breaches and warnings comes as bitcoin continues to gain visibility within Canada and beyond. A bitcoin-capable ATM went live in Montreal this week, joining others in Vancouver, Toronto, and Ottawa, while in the U.S. the Department of Justice said bitcoins could be considered a legal form of exchange. As much as the debate focuses on bitcoin, it ultimately applies to all forms of cryptocurrency, including namecoin, litecoin, and primecoin.

The latest trading halt and ongoing investor volatility both cast doubt on whether established financial infrastructure has the ability or the will to ultimately accept virtual currencies as legitimate means of payment. Despite bitcoin’s secure, encrypted architecture, it is just as vulnerable to hacking as traditional currency models, and a growing list of attacks and security breaches underscores the risks. The MtGox exchange at the heart of the latest volatility was targeted by a series of ongoing distributed denial of service attacks. The bitcoin storage service Instawallet was hacked last year, and in 2012 thieves made off with 24,000 bitcoins from the Bitfloor exchange.

Bitcoin’s latest headline-grabbing trick illustrates the dangers of judging a financial instrument using the same criteria applied to a technology. The fact that everyone is talking about it and some are dabbling in it doesn’t mask the risks lurking just beneath the surface.

Carmi Levy is a London, Ont.-based independent technology analyst and journalist. The opinions expressed are his own.

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