Digital Gold (20 page)

Things calmed down for a few hours after
Mark Karpeles assured his users that the problems were due to the volume of trade, not to hackers. But hours after he wrote that, the hackers showed up and staged fierce denial-of-service attacks, forcing Mark to shut down the site altogether in the middle of the day.

April 11, 2013

T
he day after Mt. Gox shut down under the strain of heavy trading, the members of the corporate board of Lemon, Wences Casares's digital wallet, showed up at the company's Palo Alto offices for a lunchtime meeting. The price of Bitcoin sat more than 50 percent lower than where it had been twenty-four hours earlier. But the sudden downturn had done nothing to dim Wences's faith in Bitcoin's future. Instead, it had increased his conviction that the companies dominating the Bitcoin universe, like Mt. Gox, needed to be replaced, and that he needed to do more than just be a cheerleader for Bitcoin among the Silicon Valley elite.

Lemon provided a way for customers to keep all their credit cards and coupons in digital form on their smartphones. Wences proposed to his board that they add a pocket for Bitcoins that would be a safe, reliable way to keep virtual currencies and potentially even to buy them. To get started, Wences suggested that Lemon could use $1 million of its remaining money to buy Bitcoins that could serve as an initial pool for customer purchases. This
was actually a great time to buy coins, Wences argued, because the price was down after the latest price crash.

Wences expected to see his board members light up—particularly Micky Malka, the chairman of Lemon's board and one of the first people Wences had gotten excited about Bitcoin back in 2012. Instead, Micky furrowed his brow. Is this really what Lemon set out to do? Micky asked Wences. Lemon had finally started catching on as a digital wallet. Wouldn't opening it up to virtual currencies engender all sorts of unknown legal risks?

The other board members quietly listened to Wences's explanation of why this was worth doing. They all knew it was dangerous in Silicon Valley to alienate an entrepreneur like Wences—there was no easier way to ensure that a company failed. But they didn't jump to his defense either.

After the meeting was adjourned, the board member who had looked the least skeptical, Eric O'Brien, pulled Wences aside and asked him: “How strongly do you believe in this—what are you personally doing?”

Wences didn't mince words: “I am personally allocating a percentage of my net worth to this that is borderline irresponsible because I believe in it so much.”

Regardless of what the Lemon board wanted to do, Wences said, “I would advise you to invest as much money as you can stomach losing.”

He told O'Brien to buy coins at Mt. Gox, but to move the coins off Mt. Gox as soon as the order went through.

“It is either going to be worth zero or worth five thousand times what it is today.”

I
N THE DAYS
that followed, Mt. Gox reopened for business and the price stabilized around $100. But many believed that the recent price crash proved the flaws in the whole concept. Felix Salmon,
a financial columnist at Reuters, wrote a widely circulated article pointing out that the volatile price of Bitcoin made it nearly impossible to use for its most basic purpose, as currency. If consumers didn't know whether a Bitcoin would be worth $10 or $100 tomorrow they would be unlikely to spend their coins and merchants would similarly be unlikely to accept them. Even this critic, though, saw something elegant in the network underlying Bitcoin.

“For the time being, Bitcoin is in many ways the best and cleanest payments mechanism the world has ever seen,” Salmon wrote. “So if we're ever going to create something better, we're going to have to learn from what Bitcoin does right—as well as what it does wrong.”

The day after the crash, the Winklevoss twins
finally went public in the
New York Times
with their now significant stake in Bitcoin—worth some $10 million. The interest was not restricted to the United States. A few weeks after the crash,
a national television station in China broadcast a half-hour segment on the new enthusiasts in that country, and several local entrepreneurs began setting up exchanges to buy Bitcoins using yuan.

Despite the crash, everyone with a Bitcoin idea found that there was now no shortage of eager investors in Silicon Valley. In May, Pete Thiel's Founders Fund announced that it was putting
$2 million into BitPay, the payment processing company that allowed merchants to accept Bitcoin and end up with dollars in their bank—taking advantage of the Bitcoin network's quick and cheap transactions.

But the company that was attracting the most attention was Coinbase, founded by the veterans of Airbnb and Goldman Sachs. The twentysomething cofounders had clean-cut looks and soft-spoken ways that naturally engendered confidence. Investors liked that the pair avoided the ideological talk of overthrowing the Fed and instead sold their company as a safe and easy place for consumers to buy and hold coins that wouldn't be subject to endless
delays and scrutiny from the authorities. They also had real professional experience at well-known companies, something that had been in short supply in the Bitcoin world up to this point.

After consultations with Wences, Micky decided to team up with the New York venture capitalist Fred Wilson to put
$5 million into Coinbase. It was the largest publicized investment in a Bitcoin company to date, by a wide margin, and the first time an established venture capitalist like Wilson had put serious money into the space. The rest of Silicon Valley took notice.

C
HARLIE
,
MEANTIME
,
WAS
taking advantage of BitInstant's status as the only serious Bitcoin company in New York—the media capital of the world—to become a sort of public spokesman for Bitcoin in the press. He regularly invited reporters to a bar that he had invested in at the beginning of the year, EVR, the sort of dark, swanky Manhattan club that made its clientele line up in high heels on the sidewalk. The round leather booth in the back corner was Charlie's standing nighttime office, with some top-shelf liquor on the table for guests.

Those who knew Charlie back in Brooklyn were amazed at his transformation from a short, awkward teenager into a confident impresario who bragged about the ring that he wore, engraved with the private key to one of his Bitcoin wallets. But as always with Charlie, it was all somewhat less than it appeared. He still lived in his teenage bedroom in the basement of his parents' house in Brooklyn. He left people with the impression that EVR was his bar, despite the fact that he had put in only about $15,000 and owned less than 1 percent of it. Meanwhile, Charlie's company was racing furiously to keep up with all the new competitors, especially Coinbase, and Charlie was often missing when he was needed most, hanging out at the bar or talking with reporters. At one point, Cameron
Winklevoss asked Charlie: “Do you want to be the proprietor of a bar or the CEO of a Bitcoin company? You can't have it both ways.”

Cameron, the more involved of the two twins, constantly pressed Charlie on why things weren't getting done faster. When Coinbase's $5 million investment was announced, Cameron warned Charlie that Coinbase could steal BitInstant's thunder.

“Just deliver the deliverables and stop fucking around,” Cameron told him.

Charlie meekly submitted. “OK, I will push the team and myself harder.”

I
N
T
OKYO
, M
ARK
Karpeles was also learning that Mt. Gox's first-mover advantage was not impregnable.

On May 2,
Mark was sued in a Seattle court by CoinLab, the company run by Peter Vessenes that had been scheduled to assume responsibility for Mt. Gox's business in the United States earlier in the year. CoinLab accused Mt. Gox of breaching its contract by not handing over the customers. Troubles deepened a week later when the
money in Mt. Gox's two American bank accounts—some $5 million—was seized by federal agents, who accused Mt. Gox of violating federal money-transmitting laws. It wasn't apparent at the time, but these moves were part of the net tightening around Silk Road, as law enforcement agents in Baltimore narrowed in on their prey. Prosecutors had secretly filed a sealed indictment on May 1 against Dread Pirate Roberts for narcotics trafficking and were prepared to arrest the mastermind as soon as they figured out who he was.

Given all this turbulence, it was remarkable that anyone continued using Mt. Gox at all. In the world of trading, though, the most valuable thing an exchange can offer is liquidity or, more simply, people buying and selling. An exchange with the best technology
in the world isn't worth anything if no customers are there offering to buy and sell. Mt. Gox still had liquidity because it had attracted so many customers from its days as just about the only exchange around, and some customers would move only if others did as well.

But a chasm was opening up between the early Bitcoiners and the new, more practical community of entrepreneurs, engineers, and investors. When some of the developers working on the underlying Bitcoin code set up a Bitcoin press center, it immediately led to fights about who was presentable enough to be listed as a contact for journalists, especially when Roger Ver was taken off the list. Erik Voorhees lashed out at those trying to smooth Bitcoin's sharper edges.

“It is embarrassing to see Bitcoin reduced to sniveling permission-seekers, too cowardly to speak about the real issues and the real reasons why this technology is so important,” Erik wrote. “Bitcoin is a movement, and those trying to distill it into nothing more than a cute new technology are kidding themselves and doing a terrible disservice to this community.”

E
VERYONE SEEMED READY
for a truce from the bickering as the Bitcoin Foundation's first-ever conference approached in late May. The foundation had booked the main convention center in the capital of Silicon Valley, San Jose.

On the morning of the conference's first day, Friday, May 17, the Valley news site
TechCrunch
went live with a story that officially announced the investment the Winklevoss twins had made in BitInstant, which had remained a secret even after they went public with their holdings of Bitcoin. The investment was put at $1.5 million. Even this article was the cause for a small tiff with Charlie, who had accidentally tipped off another reporter first.

“Your communication is piss poor and gums up the entire operation,” Tyler Winklevoss wrote.

But the tension quickly passed and Charlie and the twins showed up at the convention center to find that they were heroes of sorts to the assembling Bitcoin masses. Many of the conference attendees had been aficionados for years, waiting for the world to see the beauty of their pet project. Now these tall, statuesque celebrity twins were standing up for their cause. On Friday night, the twins delivered the keynote speech together, clad in sneakers and button-down shirts with rolled-up sleeves. They opened with a quote from Gandhi, and proceeded to cite Dr. Seuss and the Bitcoin pizzas purchased by Laszlo Hanecz. The next morning, when the general exhibition opened, one vendor was selling shirts with the smiling face of Charlie Shrem, in the style of Barack Obama's famous “Hope” poster.

The adulation distracted Charlie from the business opportunities at the conference. He got around to scribbling down some thoughts for his Saturday afternoon speech only an hour beforehand, while standing around the booth. The talk was unsurprisingly disjointed, but Charlie still possessed his old infectious enthusiasm, which had the crowd cheering and clapping. That night, the whole BitInstant team went out for a boozy dinner with shots of Fireball whiskey, followed by a night out at a club.

While Charlie and other Bitcoin old-timers were reveling, a more quiet and sophisticated conversation was going on around the edges. In a back room of the convention center, Gavin Andresen gathered with the four other developers who were maintaining the basic Bitcoin software that computers on the network were running. This was the first time the so-called core developers had met in person, and far from the crowds they talked about the serious work of keeping the basic Bitcoin protocol safe from hackers and forks.

The moneyed set that had recently converted to Bitcoin was also buzzing around the conference. Wences didn't speak at the conference but he had lots of private conversations with the investors and entrepreneurs whom he had introduced to the technology, including PayPal's David Marcus, who had turned his name badge around so that no one would know who he was. After browsing in the exhibition hall, Marcus told Wences that he had been appalled by the naïveté and lack of sophistication of the existing companies. When asked how they were dealing with anti–money laundering laws, none of the young entrepreneurs gave a knowledgeable answer. It was so bad that Marcus told Wences he was contemplating quitting PayPal and starting his own Bitcoin exchange—something he later decided against.

For these Silicon Valley power brokers, there was an absurdity to the old-school Bitcoiners who crowed to each other about being the leaders of a new global movement and getting rich in the process. The convention center happened to be hosting the Big Wow! ComicFest at the same time as the Bitcoin conference, and it was sometimes hard to tell who among the long-haired nerds were there for the comics and who for the virtual currency.

June 2013

T
he gap that had been revealed at the Bitcoin Foundation's conference—between the apparent promise of Bitcoin's underlying idea and the weakness of the current companies—only emboldened the big-money people going into the summer.

Pete Briger at Fortress, the private equity and hedge fund giant, invited in an old classmate from Princeton and colleague from his days at Goldman Sachs, Dan Morehead, to help Fortress look full-time at a range of virtual-currency opportunities. A tall, statuesque man, who had been on both the rowing and the football teams at Princeton, Dan looked like a member of the ruling class, and he had recently been running his own hedge fund, Pantera. After getting the invitation from Briger, Dan took up a desk at Fortress's offices in a skyscraper near the Embarcadero in downtown San Francisco. He soon hired the first professional traders to buy Bitcoins for a fund he hoped to set up, which would make Bitcoin more easily available to big investors. In New York, Barry Silbert was working on something similar. To get everyone in his company involved and excited, Barry gave each of his seventy-five
employees two Bitcoins—each worth around $100 at the time—with the mandate to spend one of them and save the other.

But as these professionals got more deeply involved it quickly became clear to them that for all the excitement around Bitcoin in Silicon Valley, almost no one had been paying attention to equally important constituencies in Washington, DC, and on Wall Street, now the most significant roadblocks to the growth of this technology.

In late May
federal prosecutors arrested the operators of Liberty Reserve, another online currency that Mt. Gox and BitInstant had used early on as a method for funding accounts. Liberty Reserve was a very different beast from Bitcoin. It was run by a centralized company, which designed the currency to make it easier for criminals to move money undetected. But the shadow of Liberty Reserve naturally fell on Bitcoin and statements from regulators suggested they did not necessarily see a big difference.

At the end of May
the top financial regulator in California sent the Bitcoin Foundation a cease-and-desist letter accusing the foundation of operating as an unlicensed money transmitter. The accusation was somewhat absurd—the foundation was not a business of any sort—but it highlighted just how little the foundation had done to cultivate relationships with the relevant regulators.

Given the regulatory uncertainty, it was unsurprising that bankers were not eager to get involved with the new industry. In 2012 and 2013 several big banks had faced $1 billion fines for not being vigilant enough in tracking money laundering. In the early summer of 2013 JPMorgan Chase, the nation's biggest bank, was shutting down accounts for any companies that came with an elevated risk of money laundering, including check-cashing businesses and companies that did remittance payments to Mexico.

Finding banks willing to open accounts for Bitcoin companies had always been a problem for entrepreneurs like Charlie Shrem.
But even the new, more powerful backers of Bitcoin were discovering that they couldn't find banks willing to work with them. Fortress's Pete Briger set up a meeting with top executives he knew at one of the nation's largest banks, Wells Fargo, about potentially teaming up to create a more secure and reliable Bitcoin exchange, but Wells Fargo quickly declined any partnership. It had been only a few months since Wells Fargo had had to deal with federal agents seizing Mt. Gox's Wells Fargo bank accounts.

In all the discouraging dealings with bankers and government officials, Bitcoiners were facing basic questions about why it was worthwhile for anyone to put any energy into this technology. Almost five years after Satoshi Nakamoto had published his paper, the virtual currency was worth real money and had attracted talented people, but although some small companies accepted Bitcoin through BitPay, the virtual currency was still used almost entirely for speculation, gambling, and drug dealing.

Economists who had taken note of Bitcoin also pointed out that the virtual currency actually had built-in incentives discouraging people from using it. The cap on the number of Bitcoins that could ever be created—21 million—meant that the currency was expected to become more valuable over time. This situation, which is known as deflation, encouraged people to hold on to their Bitcoins rather than spend them.

The notion of Bitcoiners around the world sitting on their private keys and waiting to become rich begged the question of the intrinsic value of these digital files. What were all these locked-up virtual coins really worth if no one was doing anything with them? What was backing up all the value the coins seemed to have on paper?

Bitcoin fans argued that the United States dollar was not backed up by anything real either—dollars were just pieces of paper. But this argument ignored the fact that the United States government
promised to always take dollars for tax bills, which was a real value no matter how much people disliked paying taxes.

Practically no one was promising to take Bitcoin for anything. The primary value the coins had at this point was the expectation that they would be worth more in the future, allowing current holders to cash out for more than they paid. To some cynics, that description made Bitcoin sound suspiciously like a less savory sort of financial invention: a Ponzi scheme.

F
ROM THE OUTSIDE
, it would have been easy to conclude that Charlie and BitInstant were somehow dodging all these problems. Charlie was shopping for new, larger real estate for his company and eventually settled on a well-appointed suite in an office tower. Charlie had finally managed to move out of his parents' basement in Brooklyn. He was motivated to do this, in no small part, because he was afraid to tell his parents about his girlfriend, Courtney, who was a waitress at his favorite bar, EVR. Courtney was some ten years his senior and, more important, not Jewish—something that did not fly in the Syrian Jewish community. Charlie and Courtney took a room in a big communal apartment above EVR, where there were always alcohol bottles and bongs on offer. Charlie was often spotted at EVR with Courtney on his arm.

But within BitInstant, Charlie's hard-partying ways seemed to many like an escape from the challenges he was facing with his company. The Winklevoss twins had been pushing Charlie to raise more money to pay for BitInstant's expansion. And Charlie had no trouble getting meetings with investors, who were all impressed at the sheer number of dollars already running through BitInstant. But as Charlie's team tried to get the investors the paperwork they needed, it quickly became clear how unequipped BitInstant was for the big time. When the BitInstant chief financial officer, who
was just two years out of college, tried to put together the financial statements he realized that there were large holes in the company's books, with unexplained expenses in all directions.

Charlie had made remarkable progress for a twenty-three-year-old entrepreneur with almost no prior experience. He had built a complicated business from nothing and people entrusted him with millions of dollars. But Charlie was clearly, and unsurprisingly, lacking skills as a manager. In many startups this is something that investors might notice, and help fix, by finding an experienced manager to come in and steer the ship. As it turned out, though, Charlie's investors didn't have much more experience working with startups than he did. The twins' early experience with Mark Zuckerberg had been limited and, since setting out to become tech investors the previous year, they had worked with only a few young companies. With Charlie, the twins had initially adopted a hands-off attitude, despite all the bickering. But as problems became more evident, they talked with Charlie's chief programmer about replacing Charlie as CEO. When Charlie learned about the potential palace coup he was furious and began showing up for work less and less.

In mid-June, the Winklevosses asked an angel investor they knew, Chris Morton, to diagnose BitInstant's problems. What they got back was a long list of basic things the company was missing, among them:

“There is no accounting system.

“The equity agreements are a mess or nonexistent.

“The company mission is not clear.”

But Morton's harshest words were reserved for Charlie:

He cannot focus. He seems to be busy with superfluous meetings (press, investors, partners, speaking engagements) and personal commitments (bar, rental property). Even when those meetings are in progress, he does other things
on his computer. He makes commitments and does not follow through. He confirmed a meeting with the accountant and then did not show.

The Winklevoss twins talked with Morton about coming in to help turn around the company, but he had little interest.

The twins were realizing that BitInstant might be a lost cause and they began working toward a life in Bitcoin without Charlie. At the Manhattan offices of Winklevoss Capital, where the brothers had matching glass-walled offices on either side of a glass-walled conference room, the twins started putting together the paperwork for what they envisioned as the first-ever Bitcoin exchange-traded fund, or ETF, which would hold Bitcoins and move with the value of the coins, but trade on a real stock exchange, much like the hugely popular gold ETF. The twins planned to assemble a team that would buy and sell Bitcoins, allowing ordinary investors to purchase the ETF through their Charles Schwab or E*Trade brokerage account.

I
N LATE
J
UNE
, Charlie finally managed a long-planned relaunch of BitInstant, in partnership with a money-transmitting business that was regulated in most states. But when the site went live and BitInstant began doing more thorough checks of its customers, Charlie's staffers realized that many of their customers had been doing business with them under fake identities. When the Manhattan district attorney sent a disconcerting request to Charlie asking him to come in for a meeting, it precipitated an emergency conference call with a team of lawyers on July 4.

“The problem is that the site is a patchwork of bandages,” one of the lawyers told Charlie and his team. “When we go into that
meeting, they're going to go straight to the site and review it in detail. They can't see a patchwork of quick fixes.”

The lawyers were unrelenting, and the answers from Charlie made them nervous: no, BitInstant's compliance officer had no previous experience in compliance, and no, BitInstant had not filed any suspicious-activity reports with regulators despite having lots of transactions flagged as potentially fraudulent by partners. The call concluded with a long list of things that needed to be handled immediately.

“You are very exposed on all fronts,” the lawyer told Charlie and his team.

Charlie tried to show how serious he was about complying with all the rules, but the old problems were quickly joined by new ones. A couple of customers disputing transactions filed a lawsuit, for which they were seeking class-action status. When the twins read Charlie the riot act, he responded with total contrition.

“Things ARE changing dramatically to fix problems on all fronts and put us in a position for growth as quickly as possible,” he told them. “I've made a lot of mistakes, the ones that you guys called me out on as well as others that I'm seeing now and taking steps to fix.”

But there wouldn't be time for that. Charlie was in the new BitInstant offices, which he had moved the company into less than two weeks earlier, when he got a letter from his lawyers telling him that because of the number of legal questions, they could not represent him in his upcoming meeting with the district attorney unless he shut down the site and resolved all the problems.

Charlie reached the Winklevoss twins while they were in the car on the way to their family beach house. They laid the blame entirely at his feet and demanded the return of the $500,000 loan they had made back in April when business was booming.

On Friday, July 12, at 9 p.m., Charlie took the BitInstant site down, for what he thought would be only a temporary hiatus.

T
HE MALODOROUS HAZE
now hovering over Bitcoin was making everyone question what it was doing.

Erik Voorhees, one of the most fearless proponents of Bitcoin's radical possibilities,
announced a few days after Charlie shut down BitInstant that he was selling the gambling site, SatoshiDice, which he'd bought in 2012 and turned into one of the most popular Bitcoin sites on the Web.

The sale involved reimbursing all the people who had bought shares in Erik's company in 2012, but they had only 13 percent of the site. This young man who had been unemployed two years earlier was now a millionaire living in Panama. But the reason he was selling SatoshiDice was not the money. In e-mail exchanges with other entrepreneurs he explained that his legal costs were piling up and that it was too much of a headache to be under such scrutiny.

“Bitcoin businesses are literally at the edge of law, not because they are doing anything wrong, but because Bitcoin enables new activities and behaviors and recategorizes money in such a way as to enable it to transcend current statutes. This is both exciting, and scary, because we're breaking amazing ground and we'll inevitably be in the crosshairs for doing so,” he said.

About a week after he sold the company and paid back his shareholders, he got an e-mail from the Securities and Exchange Commission letting him know that it believed that he had broken the law by selling unregistered securities. The e-mail caused a terrible feeling in the pit of Erik's stomach that didn't abate for days.

Not long after that, nearly every major company in the Bitcoin space got a subpoena from the top financial regulator in New
York, a young bulldog of a prosecutor named Benjamin Lawsky, who asked for a trove of documentation about consumer protections and anti–money laundering programs. A few days later the US Senate's Committee on Homeland Security and Governmental Affairs sent a letter to the major financial regulators and law enforcement agencies asking about the “threats and risks related to virtual currency.” Neither of these requests suggested that lawmakers regarded this new technology with much warmth.