Fundamentals of Bitcoin (in case you don’t know yet)
Bitcoin is the first decentralized cryptocurrency and, even after the still unfolding MtGox-crisis, still the cryptocurrency with the highest market capitalization. Its fundamental innovation is the combination of asymmetric cryptography and public peer-to-peer shared transaction recording (this distributed database of mined coins and transactions is called „Blockchain“). The Reuters infographic below (that I found here) provides a good overview:
What happened (in a nutshell*)
Mt. Gox, once the biggest trading platform for BTC, first had liquidity issues in connection with the seizure of a bank account by US FinCEN mid last year. As of January, MtGox apparently still had big plans. The real trouble, however, started over the suspension of any transactions from and to Mt. Gox in early February. While Mt. Gox issued a statement declaring that this was due to a „bug“ in the BTC-protocol, a core developer of the bitcoin foundation stated that the issue over transaction malleability has been known since 2011 and can be dealt with by means of an adequate wallet software (cf. here).
Transaction malleability refers to the fact that the way transactions are checked for being processed allows thir parties to confuse senders/receivers as to whether or not a transaction actually cleared. This is due to the fact that one and the same transaction might be modified (e.g. by some mining node clearing the transaction), so that a different hash is created as transaction ID. As the underlying transaction remains untouched, the new transaction hash will clear as valid. However, a sender checking for the intended transaction ID will not find it and might thus assume the transaction didn’t go through. In the end this might not be a problem in case of careful verification processes, but in case funds are automatically re-sent, high frequency traders might be affected. It is assumed that this is what happened at MtGox.
(* you can find an extended history here)
The bad news
Mt. Gox is indeed insolvent on a scale of about BTC 750,000, which is about $435 million at the current exchange rate. It appears to have been deceived into resending bitcoins. Internal documents leaked (authenticity unknown to me, but receiving some credit from insiders) and suggest at least shady handling of the issue that remained unnoticed for YEARS. It is unclear where all the money has been lost. The total loss might be a combination of automatically resent bitcoins and (in case Mt. Gox did speculate for its own profit on the exchange rate using the $ deposits of its customers*) an unfortunate development of BTC/$ exchange rate at the moment when Mt. Gox came under fire due to rising customer preoccupation over transfer malleability and other rumors.
(* Customers had at least two deposits at Mt. Gox, one in $ and one in BTC.)
The good news
Meager, but important: BTC-Protocoll appears to be intact and bitcoin is regaining market capitalization (+2.48% the last 24h to $580.99/BTC). Exploits of the malleability issue can be regarded principally as mere DoS-attacks and other BTC-traders already suspended operations until this is cleared in order to prevent further damage.
1) Bitcoin is like cash and theft is possible in spite of public transactions! Once it is transferred from your BTC-wallet, it’s gone. Sure, transactions are all public and can be traced; but once they are further transferred to a third party and the third party is a bona fide receiver, funds are lost as long as the exploiter behind the address in the middle remains unknown.
2) Intermediaries that create additional money supply based on an off-Blockchain reserve can be victims of bank runs just as traditional banks.
3) Do not automatically resend any bitcoins without double checking.
4) In spite of this crisis, general support for bitcoin seems unbroken: new BTC-ATMs emerge continuously (e.g. here and here) and the malleability issue seems to be resolvable. But it further stokes fears (probably never really resolved) that there might be further issues still unknown. Although this equally affects any cryptocurrency, and while bitcoin remains the most valued cryptocurrency, it will have to face competition from others such as Ripple, Litecoin and many other „Altcoins“. Nonetheless, while the future of bitcoin as a currency remains unclear, its contribution to virtual currencies (and beyond) is already a disruptive innovation.
Update (2014/02/28): Not a classical bank run, but a long-term mega-heist (possibly inside job)!
After a press conference with Mark Karpeles today things become somewhat clearer. It appears to be confirmed now officially that bitcoins have been stolen. Some commentators spoke of a „bank run“ when describing the Mt. Gox crisis. A classical bank run, however, can only occur to banks operating on basis of a fractional-reserve banking system. Mt. Gox did run an internal system of pseudo-bitcoins (off-Blockchain) and held reserves in a „cold wallet“, which should serve (if implemented correctly) as a kind of safe, but is NOT comparable to reserves in a fractional-reserve banking system. In fact, solvency issues arise to banks that create new money supply through lending and borrowing and consequently run a asset-liability mismatch. This is a kind of activity that Mt. Gox did not engage in as to my knowledge. Therefore their insolvency can only be the result of theft or misappropriation of some kind. This would make the Mt. Gox crisis front runner for the award of the biggest bank heist in history.
Update (2014/03/03): Read also this very insightful and witty comment that clarifies why transaction malleability is very unlikely to be the security breach and instead suggests it to be an inside job.
tl;dr: MtGox victim to mega-heist (probably inside job). IMHO, cryptocurrencies will last.