Financial Impact of Mt. Gox Issues

EDIT: If you want to see my original post on Reddit, it is here. So far not many people are responding. Makes me sad. http://www.reddit.com/r/Bitcoin/comments/1xeez8/financial_impact_of_mt_gox_issues/

Posted this on Reddit, but figured I'd share it here as well for discussion. Please note that I am not a professional investor.

With rumors going around that Mt. Gox is insolvent, one should naturally wonder what consequences this may have if the rumors are indeed true. My goal is to outline these possible consequences in a clear way so that people here can discuss them.

Historically, when a financial entity collapses, investors automatically assume that the next "weakest" financial entity in the market is likely to collapse as well. This causes the investors to make a run and pull out as much fiat as they can before the entity goes insolvent. This is what happened on Wall Street with the collapse of the housing market in the United States.

One should wonder, are the financial entities (the cryptocurrency exchanges) vulnerable to something similar? The answer is that it depends. We know that most of the major exchanges operating right now make their profits from commission. They aren't operating on the assumption that they will receive payment from loans or anything like that. They just keep commission on trades. And since exchanges just allow people to exchange (with other traders) their fiat for cryptocurrency/vice versa, there shouldn't be a problem if people make a run on the exchanges trying to withdraw all their fiat; there is no risk of them going insolvent. Right?

Well, this is true if the exchanges aren't investing the fiat that people are sending to them. But we don't know if this is the case. What we do know is that we send them fiat, and the exchanges give us fiat "credits" in return that we can trade with. We know that a lot of fiat goes into these exchanges just for flipping, and that not all of the fiat that goes into the exchanges comes out any time soon. Hence, the exchanges have a surplus floating around in their pockets.

If the exchanges are investing that surplus fiat (in other words leveraging with loans supplied by the people depositing fiat into the exchanges), then we might be in trouble. If people make a run on exchanges to withdraw their fiat, and if the major exchanges are investing the fiat they have from the depositors, then they all face a risk of going insolvent if Mt. Gox goes insolvent. The absolute worst possible case if is the exchanges are using the fiat from depositors to invest in cryptocurrencies.

What do you guys think?

 

You kind of just basically gave a 101 introduction to investing. Anyone that invests should know the risks associated with holding their money in any sort of financial institution.

Theoretically the exchanges shouldn't be invested in ventures with customer capital because they're just that - an exchange. They're a middle man that facilities trades between parties. It is like the difference between going to Chile and trading your US dollars in a shady back alley or going to the embassy and exchanging. The embassy is the exchange and they generally give you a worse rate than taking the risk of exchanging directly, but you get the promise that your money is (generally speaking) safe. If you trade with a shady guy in a back alley then you take the risk of getting stabbed and robbed.

It is all conspiratorial right now and a panic will cause a market dip, and if it is serious enough it could bottom out the prices. That is when I'd sell everything I could and buy some BTC up, because BTC is a serious part of the internet and internet culture so it will recover.

 

The lack of regulation of crypto exchanges prevents them from being that great embassy.

I do agree that crypto is a part of the future. But there is no guarantee that Bitcoin, Litecoin, or any other current coin is going to be successful. The underlying technology though is quite promising.

I am really quite excited to see where this all leads in the next few weeks/months. Although I unfortunately lost all my profits and have made a small loss (I was slightly leveraged) on this, I've decided to cash out. If Gox collapses, there very well may be a domino effect. And I'd rather not deal with that.

 

I was just talking quid pro quo. In a perfect world exchanges should be safe, just like physical currency markets.

 

UPDATE: Mt. Gox's website is down.