Bitcoin Scandals Increase Skepticism About Currency's Trustworthiness

NEW YORK (TheStreet) -- Even as mainstream awareness about bitcoin and its possibilities has grown over the past year, the digital currency's volatility has become a cause of worry for investors.

New this week that a bitcoin exchange in Hong Kong had suddenly closed, taking with it some $386 million worth of investors' money, mark the latest in a long list of hacks and scandals that have plagued the currency. It's also further evidence of what critics say are fundamental problems with the currency.

"Bitcoin is built with clay feet," said Mark Williams, a risk management expert and bitcoin expert at Boston University. "It isn't built with a focus on trust."

Williams says the currency has a number of structural flaws that have helped to undermine trust.

The first flaw is a hoarding problem. A total of 13 million bitcoins have been mined from the currency's finite limit of 21 million.

Courtesy of John Ratcliff

According to a Bitcoin Distribution Chart (based on information from Bitcoin's public ledger) prepared in January 2014, approximately 309,793 addresses contained 99.1% of all bitcoins mined.

But in April, Jonathan Levin from Coinometrics, a bitcoin analytics firm, said that only 250,000 addresses within Blockchain, the currency's transaction ledger, had more than a single bitcoin.

Regardless of the actual number, the fact remains that a limited number of people own a majority of the currency. "Ninety-percent (of Bitcoins) are being hoarded," said Williams. That makes the currency "inherently susceptible" to volatility, he said.

According to Williams, the currency's "on-and-off ramp" processes (or, the manner in which bitcoin is generated and transactions are conducted) have also eroded trust in the currency. Currently, bitcoin is generated by a bank of computers, which solve or hash complex problems.

The decentralized nature of this network makes it possible for anyone with access to a large bank of computers and bitcoin mining operations to control currency prices. There is already speculation that Chinese bitcoin miners increased the currency's volatility last year.

There is also the problem of illegal transactions conducted over the Deep Web. Unsavory entrepreneurs laundering money or making payments for drug transactions have already staked their ground in the largely unregulated landscape of the bitcoin ecosystem.

They generate negative publicity for the currency. For example, the recent high-profile trial of Silk Road owner Ross Ulbricht was splashed all over prominent Web sites. Williams refers to such cases as Bitcoin's PR problem.

Bitcoin's proponents blame negative media coverage for Bitcoin's trust problem.

"This is a myth perpetuated by multiple negative stories in the media," said Tony Gallippi, chief executive officer at BitPay, a bitcoin payment processor. He said the public nature of bitcoin's ledger is designed to prevent illegal transactions.

But the ledger consists of public transactions conducted by anonymous entities. Thus, it becomes difficult to identify the source and recipient in such transactions.

Gallippi said the anonymity of transactions ensures user and business privacy. "You don't want people to know your business secrets or all your debit or credit card transactions by looking at the public ledger," he said.

In response to adverse news, startups such as bitcoin payment processor and exchange Coinbase, have instituted measures including cybercrime insurance and tough security to build trust with users.

But they are riddled with "inherent conflicts of interest," said Williams.

According to him, Coinbase has an incentive to buy low and sell high as a trader in bitcoins. But, the startup's operations as an exchange provide it with access to "privileged and timely market price data."

Williams said, "Are they serving clients first or their own interests? The SEC wouldn't allow them to operate as an exchange if they were financial intermediaries."

Williams said startups operating in bitcoin should seek greater regulation to promote trust in the currency.

"If I were Coinbase, I would embrace regulation," he said.

Coinbase refused to comment for this article.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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