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What the heck just happened to bitcoin? And what the heck is bitcoin, anyhow?

The Exchange

The price of the virtual currency bitcoin plummeted this week after a leading bitcoin exchange, Mt.Gox, shut its doors. The Tokyo-based firm already suspended customer withdrawals two weeks ago, citing a possible flaw in the system. But on Monday Mt.Gox suddenly closed its website and disappeared.The site is now blank aside from a brief message from owner Mark Karpeles and a statement explaining: "In light of recent news reports and the potential repercussions on MtGox's operations and the market, a decision was taken to close all transactions for the time being in order to protect the site and our users. We will be closely monitoring the situation and will react accordingly."

Just what is going on with Mt.Gox, and is this the end of the line for the controversial and volatile Internet-born currency?

Remind me again, what the heck is a bitcoin?

A bitcoin is nothing more than some lines of digital code; it has no physical form like a metal coin or paper bill. Based on computer encryption techniques, each bitcoin code is unique, like a serial number, and must be stored carefully in a digital wallet on a computer, mobile phone or other device. Lose the lines of code, say if a hard drive is destroyed, and the bitcoin is lost forever.

But the all-digital nature of the currency makes it easy to trade from anywhere in the world nearly instantaneously and without transaction fees. Whenever bitcoins are exchanged, the transfer of ownership from one wallet to another is validated and recorded in a huge, public log file known as the blockchain.

And how much is a bitcoin worth?

The value of one bitcoin has fluctuated wildly, from a few cents when the currency started trading in 2009 to more than $1,000 earlier this year. Since the latest Mt.Gox incident, the price has plummeted to under $500. The value is set on the open market – a bitcoin is essentially worth whatever people are willing to pay for it at any given time. That’s not unlike most foreign currencies but, in the case of bitcoin, there is no central bank or other authority overseeing the market – bitcoin users and businesses must agree on the rules of the road through consensus.

So where does Mt.Gox fit in?

As the bitcoin economy has grown, a number of exchanges have sprung up to help people buy and sell the currency. In some ways, they operate much like any firm that exchanges currencies. They stand ready to exchange dollars, euros and other standard currencies for bitcoins and back again. And they post the rates at which they are willing to buy and sell, just like regular currency exchanges.

Mt.Gox, based in Tokyo, was one of the largest bitcoin exchanges in the world and its conversion prices were widely cited as nearly the standard price for bitcoin. As a convenience to its users, Mt.Gox also stored bitcoins in user accounts, much like a brokerage firm or bank might keep a customer’s stocks, bonds, cash and other investments.

Hey, you said “much like” a brokerage firm or bank – what’s the difference?

Ah, here’s where the whole decentralized, unregulated aspect of bitcoin comes into play. In the United States, banks and brokerage firms operate under exhaustive government regulation and oversight. And customer funds are insured in case the institution where they are on deposit fails (by the government in the case of banks and by the private Securities Investor Protection Corporation in the case of brokerage firms).

But firms dealing in bitcoin operate in a much murkier regulatory world. Some countries have chosen to regulate bitcoin like a currency or investment asset but others have not. Japan, where Mt.Gox was based, did not regulate bitcoin exchanges, and the country’s leading regulator, the Financial Services Agency, says it has no jurisdiction. According to a report written for Mt.Gox, the exchange has lost almost 750,000 bitcoins in customer accounts, possibly to hackers, worth some $350 million at today’s price. Needless to say, Mt.Gox accounts were not insured.

So what exactly went wrong at Mt.Gox?

The firm obviously doesn’t have a long track record operating in financial markets. It was started by an unemployed software programmer named Jed McCaleb in 2009 as a website for people to exchange cards used in the game Magic: The Gathering. The site’s name was shorthand for Magic: The Gathering Online eXchange. A year later, McCaleb added bitcoin trading and then sold the firm to Mark Karpeles in 2011.

Under Karpeles, Mt.Gox grew rapidly, though with occasional hiccups. In June 2011, a hacking incident distorted bitcoin prices and last February some transactions were canceled due to new rules imposed by online payment system Dwolla. Then in May and June, U.S. authorities seized some $5 million from the company’s accounts as part of a money laundering investigation.

But Mt.Gox continued operating until February 7 of this year, when the exchange abruptly suspended all withdrawals from customer accounts. Karpeles said the exchange had discovered a flaw in the way bitcoin transactions were recorded that might allow fraudulent dealings. Many others said the explanation didn’t make sense.

With withdrawals still suspended, the Mt.Gox site suddenly went offline this week and Karpeles resigned from the board of the Bitcoin Foundation, the nonprofit that helps organize the digital currency’s leading players. Blogger Ryan Galt, who tracks the bitcoin economy closely, posted what he called an “unverified” report purportedly drafted by Mt.Gox warning that 744,408 bitcoins had gone missing and offering a plan to save the exchange. Karpeles later verified that the document was legitimate but called it a draft, "not things that are actually planned and/or done."

Do Mt.Gox customers have any recourse?

Short answer: no. Longer answer: As recounted above, Mt.Gox has been struggling to remain stable for quite some time. In an unregulated ecosystem like bitcoin, the machinations should have been a major warning sign to customers. Those who didn’t heed the warning signs are likely suffering the consequences today. Legal authorities in the U.S. and Japan are also reportedly looking into the matter.

So that’s it – game over for the whole bitcoin economy?

It’s certainly possible the Mt.Gox collapse will destroy public faith in bitcoin and lead to its eventual demise. But that’s not a certainty. A growing number of U.S. venture capitalists have been trying to build a network of legitimate, stable companies operating in the bitcoin economy. Famed VC Marc Andreesen predicted in a January op-ed in the New York Times that bitcoin would eventually become a major economic force. After the Mt.Gox collapse, a group of those companies issued a statement seeking to salvage bitcoin's reputation.

This tragic violation of the trust of users of Mt.Gox was the result of one company’s actions and does not reflect the resilience or value of bitcoin and the digital currency industry. There are hundreds of trustworthy and responsible companies involved in bitcoin. These companies will continue to build the future of money by making bitcoin more secure and easy to use for consumers and merchants.  As with any new industry, there are certain bad actors that need to be weeded out, and that is what we are seeing today.

The group pledged to take further steps to reassure customers. In that direction, a well-known New York financial services firm, SecondMarket, announced it was establishing a whole new kind of bitcoin exchange. SecondMarket's system would be more like the New York Stock Exchange, where legitimate financial institutions would join a common trading platform to trade bitcoin.

That would be a far cry from the trading-card origins of Mt.Gox.