Bitcoin burglar shadow

The fear of MtGox’s potential insolvency has shaken the entire bitcoin ecosystem.

Many in the Bitcoin community are beginning to demand “proof-of-reserve” from their exchanges and financial services in the aftermath of MtGox ceasing withdrawals and committing some of the worst public relations the community has ever seen (and that says a lot considering Bitcoin’s history in the dark-net).  In fact, Bitcoinity is offering free advertising space to the first exchange that implements a way to prove that customer funds are secure, without divulging sensitive information.  There are some ideas of how to do this, with a strong consensus that it would be an asset to the community by providing greater trust levels; preventing future panics like we have seen in the last few weeks.

Combating “Fractional Reserve”

Fractional reserve is the method by which banks only keep a percentage of customer’s money on hand, and invest or loan out the rest in various ventures.  Many Bitcoin users became interested in Bitcoin in order to avoid exactly this, as it gives the financial institution an undeserved amount of power while forcing the customers to absorb all of the risk should the institution fail in its ventures.  For examples of why fractional reserve can be destructive, think about the U.S. taxpayers bailing out businesses during the last recession, or during The Great Depression when the bank-run resulted in banks ceasing all operation for a short time.

The idea of transparent reserves is not entirely new, as Coinkite already provides a measure of this.  Coinkite is not an exchange, but still felt it necessary to provide this level of transparency to its customers well before the latest MtGox saga.  With Coinkite, you can view your own account audit report and confirm it against the blockchain.  I asked Coinkite founder Rodolfo Novak why they felt it was necessary to go to such lengths to provide transparency and he had this to say;

We believe in Bitcoin done on the Bitcoin way with that in mind we designed our system to be BIP 32 HD from day one.  All funds are segregated and allocated to user’s own private keys.  All transactions are Blockchain transactions.  This is the opposite of fractional reserve and the opposite of how many other wallets and bitcoin business run.  It was a huge challenge, we had to write our own interface to the blockchain and create secure means to store it, that was done with the creation of our own HSM.

This was an exercise to build the wallet we wanted for ourselves.

What makes Coinkite system work is the fact that it is all taking place on the blockchain, the public ledger that makes Bitcoin work.  Considering exchanges may process millions of micro-trades every day, this system would prove to be very cumbersome for them to implement.

Verifying Funds Off The Blockchain

Developers like Gregory Maxwell (gmaxwell) are already trying to come up with ways to confirm account funds off of the blockchain, but without publishing information that could be used to attack the exchange or users.  You can read his ideas as collected by “iwilcox” here.  Essentially, you would need a series of nodes that know where the exchange’s storage is on the blockchain, and would have access to individual account balances.  The nodes would be layered in such a way that they could confirm that one user’s funds are included in storage, but not have access to the number of total accounts or anyone else’s balance.  As long as the node system is operated in a trustworthy way, the Bitcoin system could trust that an exchange is operating honestly.

Background

After MtGox halted withdrawals, blaming  “a flaw in the bitcoin software,” many customers demanded reassurance from the company that their funds were still protected.  Bitstamp, a Europe-based exchange explicitly stated in its press release that “no funds have been lost and no funds are at risk. ”  No such statement was given by MtGox, and when the WSJ asked CEO Mark Karpeles about the companies solvency, he responded by saying that the matter was confidential.  This instilled no confidence in the Bitcoin community, leading some to panic over MtGox’s potential insolvency, and others to discuss ways exchanges could provide evidence that they possess enough funds to handle massive withdrawals.