Fixing Bitcoin’s shaky exchange infrastructure

Danny Bradbury
Jun 4, 2013 at 10:57 UTC
Updated Feb 24, 2015 at 11:18 UTC

September 14th will be a big day for Jered Kenna. The former Marine knows a thing or two about hard sprints, which is exactly what he’s facing this summer.

Kenna is CEO of Tradehill, a bitcoin exchange focusing on high net worth individuals. Based in California, it calls itself the “single most secure and reliable major bitcoin exchange platform”. It has never been hacked, it says. Indeed, the site, which launched on March 18th, hired tech staff from Google and Cloudflare (which specialises in mitigating DDoS attacks). When you’re dealing with professional investors, you don’t want to make any mistakes moving their money around.

But Tradehill faces other challenges. On the day it launched, US financial regulator FinCEN released its regulation on virtual currencies, confirming that anyone selling units of a decentralised virtual currency to another person for real currency or its equivalent is a money transmitter.

That means bitcoin exchanges like Tradehill would have to register as a money transmitter with the federal government. That is the easy part, says Kenna, requiring little more than a single page form. The hard part is getting the relevant licence in each US state. They all have different rules, and some (sources single out New York and California) are particularly difficult.

Time (at least a little of it) is on Tradehill’s side, however. Even though the FinCEN guidance came into immediate effect, it only applies to businesses 180 days after they begin trading in bitcoin. This gives it until mid-September to get its paperwork in order.

Not all exchanges have been as rigorous as Tradehill, however. Many have fallen, suffering closure due to regulatory squabbles, or technological failures. Indeed, researchers at Southern Methodist University and Carnegie Mellon found that 45% of bitcoin exchanges established over a three-year period closed. Even more alarming is the customer redemption rate: half of those exchanges failed to return customers’ funds. Just how stable is the community of bitcoin exchanges?

“Nearly half of the exchanges that we recorded being operational later decided that they wanted to close for one reason or another,” says Tyler Moore, assistant professor of computer science at Southern Methodist University, and co-author of a study called Beware the Middleman: Empirical Analysis of Bitcoin-Exchange Risk. “It could be because they were not a good business opportunity, or they ran out of the funds or they scammed their customers.”

Regulatory hassles are a huge problem, which is why Kenna is taking such care over his own legal position.

“Treat bitcoin like the bank would treat cash,” he advises, when describing what makes a good exchange. The problem is, many exchanges don’t. “A lot of bitcoin exchanges completely lie to the banks, and they don’t tell the banks that they are a money service business, or exactly what they do. And when the bank finds out, that’s the end of the relationship,” he warns.

Several exchanges have been forced to shut down after having their bank accounts pulled in recent months. Bitfloor shutdown in April after its bank account was closed without its consent. Bitcoin-24, which was for a while one of the largest European exchanges, closed its doors after its Polish and German bankers pulled its accounts, apparently at the behest of law enforcement. At the time of writing, the German seizure had been lifted, although Poland was still locked down.

Other exchanges have also been hit by regulators. Mt. Gox had its US assets seized by the Department of Homeland Security, after it emerged that the Japan-based exchange was not registered in the country as a money transmitter. But Mt. Gox has survived the onslaught, and still controls the lion’s share of bitcoin trades.

Competition and diversity are indicators of a successful and evolving ecosystem, whereas monocultures rarely flourish. It could be that a more diverse exchange landscape would nourish Bitcoin and other altcurrencies – but as charts show, volume distribution between different exchanges is far from equal.

“It’s hard to get money in and out of Mt. Gox,” complains Jesse Heaslip, co-founder of Bex.io, a Vancouver-based start-up that will launch a cloud-based ‘roll your own’ exchange platform this summer. He says that he formed his company because the market needed viable alternatives but that it can be hard to get critical mass as an exchange. “The real issue comes down to liquidity,” he says. “The reason that Mt. Gox is Mt. Gox is because it has the capability to fulfil orders quickly.”

Liquidity – the ability to fulfil orders quickly – is a crucial factor in trading volume. Trading volume is a key characteristic for a successful exchange, says Moore. “One key finding from the paper is that the trading volume that the exchange was able to sustain impacts whether or not it will close,” he says. “Higher volume exchanges are more likely to stay open and not shut down.”

Liquidity has certainly been a problem for others in the past. Australian exchange Bit Innovate was unable to meet its trading commitments during the notorious April trading spike, because it didn’t have enough bitcoins to go around.

“We are going after the liquidity problem,” says Bex.io’s Heaslip. “Our goal is to link together exchanges and create a bigger pool of liquidity.” A cross-filling mechanism on Bex.io will enable customers to fill orders between their exchanges quickly, to avoid them running out of coins.

There’s a trade-off between volume and security, says Moore. Trading volume may help to cement an exchange’s position and keep it alive, but the SMU/CM study found that exchanges with a higher trading volume were more likely to suffer a security breach, presumably because hackers are drawn to exchanges with bigger wallets.

DDoS attacks are rife in the cryptocurrency world, and several exchanges have been hacked, including Mt. Gox. Nevertheless, all of this leaves Mt. Gox as the incumbent exchange, with a handful of other relatively large players, and then a whole shoal of very small fish.

Some of these small fish swim quickly, though, and have innovative business models that stop them needing to handle bitcoin-to-fiat transfers at all. Instead, they let their users do it and just act as escrow services.

One of them is localbitcoins.com, which is designed for bitcoin-to-fiat currency trades on a local basis. As Jeremias Kangas, the founder of the site, explains, ‘local’ is now open to interpretation.

Users of the site with registered accounts can make a request to buy or sell bitcoins for fiat currency. They can either meet in person to complete a payment, or they can make the fiat exchange via a banking system.

“At first, we were only a local cash exchange, but then people wanted to trade online,” Kangas explains. So, he introduced support for other payment mechanisms. These include PayPal or a mutually accepted banking system, turning localbitcoins.com into a physical or Internet-based, person to-person trading mechanism.

The system uses an escrow account to hold bitcoins, and enables the sender of bitcoins to release them when the fiat payment has been received. Bitcoins must already be stored in a sender’s localbitcoins.com wallet before they can be sold, and bitcoin sellers gain a higher reputation score each time they successfully make a trade. The number of bitcoins that can be sold is linked to that score.

“I am enabling trades between users that cannot be closed down,” explains Kangas. “We don’t rely on any bank accounts.”

However, there are potential drawbacks, as Kangas points out on the site. Transactions via transfer mechanisms such as PayPal can easily be revoked, opening up bitcoin sellers to fraud.

Nevertheless, there is clearly a demand for this. The site is currently trading at a volume of 800 bitcoins per day, and takes 1% from every escrow transaction. It has users from 500 cities in 140 countries. On the day that he spoke to Point desk, Candice took on 250 additional users, showing how quickly the site is gaining traction.

“The advantage to end users is speed, and less paperwork bureaucracy,” he says. “You can create an account instantly, and if you find a trader, you can trade immediately with them.”

Others are attempting to formalise this exchangeless decentralisation, introducing proprietary technologies to reduce the fraud risk. MetaLair, a group of techies from Sussex, UK, is still working on its peer-to-peer decentralised crypto currency exchange, which relies on open source client software. In its mechanism, a multi-signature transaction is used with an escrow party, which monitors the transaction and releases the funds when the other parties to the transaction fulfil their responsibilities. The parties to the transaction can choose how many third parties they would like to confirm that the transaction has taken place.

The company is still working on the system, and may well launch an automated escrow service that only supports transactions between crypto currencies to begin with. If this happens, it will potentially extend to exchanges between crypto currencies and fiat currencies later.

However these decentralised ‘exchangeless exchanges’ fare, there is a need to make exchanges more geographically diverse, says MetaLair’s co-founder Jonathan Turrall. “We’re all aware of the problems with the Argentinian financial system,” he says.

Argentina has been rocked by a series of currency crises, and has seen its inflation rate rise to around 25%, as leaders have pledged not to devalue it. The country has been using capital controls to throttle an exit from the peso. No wonder that advocates are making movies about the Bitcoin in Argentina, and that Tradehill is said to be planning an office there.

“If we could get better representation of these exchanges in these territories it would start to benefit bitcoin and its users,” asserts Turrall.

As things stand, though, the US dollar still represents the lion’s share of trades, at 79% (with the Euro and the Chinese Yuan coming a distant second and third, respectively). And in volume terms, Mt Gox’s USD exchange is still the clear winner. But things may be gradually changing.

Screen Shot 2013-06-03 at 7.27.38 PM

This chart shows the trading volumes of the largest three USD exchanges – Mt. Gox, Bitstamp, and BCT-E, over the last six months. Each data point represents the weekly average trading volume for each exchange, as a percentage of the three (1 = 100%). Mt. Gox has been losing ground in the last month after a mostly steady run. Could it be a blip, or could it be an erosion of trust after Mt. Gox’s recent travails with the US government? As market awareness of BitCoin increases, might other exchanges begin to eat away market share?