Mt. Gox Withdrawal Freeze Driving Significant Liquidity Concerns

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Mt. Gox, the leading bitcoin exchange by market share, recently declared a two-week hiatus on USD withdrawals. The company cited increased volume as a source of difficulty for their bank to process transactions within a normal time frame. Upon the completion of the two weeks, the company announced the end of the hiatus, though a significant back-log of withdrawals would mean at least another two weeks of delays.

This is not the first time such an action has been taken by Mt. Gox. In 2012, a number of their customers encountered withdrawal delays as well. Gox’s response was similar, citing changes with one of their payment processors as the root cause. While it raised concerns at the time, Gox eventually filled the withdrawal orders and continued to grow alongside the bitcoin market.

While that may offer some reassurance, there are a number of important differences between the withdrawal delays in 2012 and the ones occurring more recently. The delays in 2012 affected a reported 9% of total USD withdrawals, compared with 100% currently. Additionally, the expensive regulatory compliance Gox now faces, loss of a key payment processor, and an unknown amount of funds seized by the Department of Homeland Security paint a more disconcerting picture. Given the trading volume over the past six months and associated fees, it’s unlikely the company is insolvent, but a significant USD liquidity squeeze is quite plausible.

Questions Remain

In their initial announcement about the withdrawal hiatus, Gox cited “rising volumes of deposits and withdrawals from established and upcoming markets” as the reason their bank was having difficulty processing transactions. It is possible that increased transactions from high-risk countries could trigger anti-money laundering (AML) stall points with their banking transaction flow, but it is suspect for them to claim an increase in deposits as trading volume slid more than 60% between May 1 and the day before the announcement on June 19. Additionally, only withdrawals were frozen, not deposits.

trading volume

Trading volume has fallen significantly since the times Mt. Gox was able to adequately service withdrawals.

Raising additional questions is the continued back-log of transactions, with countless complaints about delayed withdrawals still ongoing, despite Gox’s assertion that they serviced $1 million of withdrawals and “are literally going to use our manpower to process withdrawals ourselves, manually.”

So What’s Going On?

It very well may be true that Gox is dealing solely with hurdles presented by the legacy banking system. Their change in SWIFT codes (previously MHBKJPJT, now MHCBJPJT) indicates a change from a retail bank account to a corporate bank account, perhaps somewhat corroborating their story.

On the other hand, concerns have been raised about Gox’s solvency and their ability to service withdrawals at all. While insolvency is unlikely given the tremendous trading volume so far in 2013, it’s quite possible Gox is experiencing USD liquidity issues and is using the withdrawal hiatus in an attempt to catch up on their liabilities.

Using reports issued by Mt. Gox in January 2012 and August 2012 (interestingly, similar transparency reports have not been issued in nearly a full year), we can approximate what their revenue and expenses look like so far in 2013. As the below chart indicates, Gox has likely generated more than $4.5M in USD-denominated fees on USD trading alone this year, or approximately 10x their estimated expenses for the same period, even with fees waived amid technical malfunctions during peak trading days in April.

Revenue and cost chart

Mt. Gox revenue and cost structure. Blue figures are hardcoded inputs from Gox’s reports or basic arithmetic. Black figures are pulled from data sources. Green figures are calculations based on inputs. Orange figures are hardcoded assumptions based on previous years’ figures.

Despite all that income, Gox faced a number of recent headwinds that could dramatically impact their USD liquidity. Most notably, on May 14, the Department of Homeland Security (DHS) seized the account Gox used to process Dwolla payments. While the exact amount within that account remains unknown, the implications of that seizure may be significant, particularly when compounded with other events in Gox’s rocky 2013 timeline.

While a portion of Gox’s USD assets were seized approximately four weeks before the withdrawal hiatus, bitcoin’s leading exchange also faces a number of significant USD liabilities. For example, they’re almost certainly paying US attorneys to handle the DHS investigation. Those attorneys most likely require timely payment in USD.

In an attempt to prevent events like the account seizure, Gox filed for registration as a Money Service Business. The road to obtaining registration as a money transmitter is both arduous and expensive. Patrick Murck, General Counsel for the Bitcoin Foundation, stated that he hasn’t seen it done for less than $2 million. Once again, Gox is faced with potentially millions in USD legal expenses.

That’s quite a heavy burden in USD legal expenses, but it’s also not the full extent of it. Gox is also facing a $75 million lawsuit waged by Coinlab after allegedly breaking an agreement to allow Coinlab to service their North American accounts. Sections 33 and 34 of the lawsuit filing expand on Gox’s unwillingness to share “databases and other related records and data pertaining to any and all accounts for customers in the United States and Canada,” as was agreed upon in their initial contract, raising suspicions about how customer accounts are being handled.

The Perfect Storm

It’s clear that in the last two months Gox faced the seizure of USD assets while also incurring significant USD-denominated liabilities. While it’s possible they could service these liabilities from their treasury accounts, it’s not inconceivable to think that, facing a potential liquidity crisis, Gox drew from USD in customer accounts to cover any shortfall in treasury account USD. MF Global, a leading broker-dealer run by former Goldman Sachs CEO Jon Corzine, recently commingled customer accounts with firm assets – it would be foolish to dismiss the possibility of a bitcion exchange doing the same.

Like all such schemes, that plan wouldn’t necessarily present a problem, so long as they could eventually fund the accounts again before anyone notices. In the case of a bitcoin exchange, the expectation would likely be to swap BTC to USD to return funds to the accounts. Unfortunately, the market fell precipitously from $110-135/BTC in early May to below $70/BTC last week, making rate exposure a major issue for anyone planning to execute such a plan.

In addition to the market’s own fundamental movements from the negative news of major exchange freezing withdrawals, that same exchange selling BTC into the market would create significant technical pressure on the BTC/USD rate, exacerbating the problem. Such a situation might even lead to a “back-log of withdrawals.” In fact, the back-logs are so significant and widespread that there are even community bounties available for anyone who can prove Gox serviced a withdrawal. There’s at least 0.5 BTC waiting for you if you can do so.

If the scenario described above is a reality, complete insolvency is unlikely unless there were a tremendous drop in BTC/USD exchange rates, compounded with an increase in withdrawals. While no scenario is impossible, as shown in the chart earlier, Gox has generated well over 100k BTC in fees. If those can be swapped to fiat in a timely manner, they would likely be able to appropriately balance their accounts.

Transparency Needed

Most of these concerns would be mitigated by greater transparency and accountability. There are a host of ways a bitcoin exchange could increase user comfort during situations like this. The most significant would be an audit by a trusted third party – common practice for financial institutions. Reports similar to the ones issued in 2012, with greater sophistication now that the market has grown so much, would also be a welcomed improvement. Right now, customers of the market’s largest exchange have only blog and facebook posts from the company to rely on for information.

It is possible this is all a result of the legacy banking structure, as Gox has implied through their statements – those difficulties are a core driver of bitcoin adoption in the first place. Unfortunately, with so little transparency, the truth is difficult to know for sure. Either way, skepticism of counterparties is a healthy trait for investors in any market and the time for greater decentralization of exchanges is clearly long overdue.

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