Bitcoin and Cryptocurrency Technologies

seen exchanges that fail due to break-ins. In fact, the statistics are not encouraging. A study in 2013
found that 18 of 40 Bitcoin exchanges had ended up closing due to some failure or some inability to
pay out the money that the exchange had promised to pay out.
The most famous example of this of course is Mt. Gox. Mt. Gox was at one time the largest Bitcoin
exchange, and it eventually found itself insolvent, unable to pay out the money that it owed. Mt. Gox
was a Japanese company and it ended up declaring bankruptcy and leaving a lot of people wondering
where their money had gone. Right now the bankruptcy of Mt. Gox is tangled up in the Japanese and
American courts, and it's going to be a while before we know exactly where the money went. The one
thing we know is that there's a lot of it and Mt. Gox doesn't have it anymore. So this is a cautionary
tale about the use of exchanges.
Connecting this back to banks, we don't see a 45% failure rate for banks in most developed countries,
and that’s partly due to regulation. Governments regulate traditional banks in various ways.
Bank regulation​. The first thing that governments do is they often impose a minimum reserve
requirement. In the U.S., the fraction of demand deposits that banks are required to have in liquid
form is typically 3-10%, so that they can deal with a surge of withdrawals if that happens. Second,
governments often regulate the types of investments and money management methods that banks
can use. The goal is to ensure that the banks’ assets are invested in places that are relatively low risk,
because those are really the assets of the depositors in some sense.
Now, in exchange for these forms of regulation governments typically do things to help banks or help
their depositors. First, governments will issue deposit insurance. That is, the government promises
depositors that if a bank that follows these rules goes under, the government will make good on at
least part of those deposits. Governments also sometimes act as a “lender of last resort.” If a bank
gets itself into a tough spot, but it's basically solvent, the government may step in and loan the bank
money to tide it over until it can move money around as necessary to get itself out of the woods.
So, traditional banks are regulated in this way. Bitcoin exchanges are not. The question of whether or
how Bitcoin exchanges or other Bitcoin business should be regulated is a topic that we will come back
to in chapter 7.
Proof of reserve​. A Bitcoin exchange or someone else who holds bitcoins can use a cryptographic trick
called a proof of reserve to give customers some comfort about the money that they deposited. The
goal is for the exchange or business holding bitcoins to prove that it has a fractional reserve — that
they retain control of perhaps 25% or maybe even 100% of the deposits that people have made.
We can break the proof-of-reserve problem into two pieces. The first is to prove how much reserve
you’re holding — that's the relatively easy part. The company simply publishes a valid payment-to-self
transaction of the claimed reserve amount. That is, if they claim to have 100,000 bitcoins, they create
a transaction in which they pay 100,000 bitcoins to themselves and show that that transaction is valid.
Then they sign a challenge string — a random string of bits generated by some impartial party — with
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