Bitcoin Market Stabilizes After Crash: Could the Virtual Currency Become a Haven for Cyber Crime and Terrorists?

Benjamin Reeves   |  March 12 2013 1:05 EDT

Something went amiss last night in the weird shadow world of the Bitcoin virtual currency. Bitcoin prices dropped a precipitous 23 percent Monday evening because of a technical glitch which interfered with Bitcoin transactions and Bitcoin "mining," the process of cryptographically creating the digital currency. The sudden drop in price was the result of a technical glitch, and the price of the virtual currency quickly rebounded. Although the long-term impact of price fluctuations on the Bitcoin market is unknown, the ability of the market to stabilize itself after the technical glitch may make the currency increasingly appealing to cyber criminals, money launderers and terrorists.

The virtual currency dropped 23 percent from record high values of close to $49 to around $37 overnight.  The drop in price came after a glitch wherein some so-called Bitcoin miners (individuals who cryptographically sequence new Bitcoins) began creating currency with a different version of the Bitcoin mining software than the market as a whole was using. Once this took place, the market for the virtual currency was forced to shut-down until all transactions and currency could be reverted to the previous version of the Bitcoin mining software.

In the words of Bitcoin.org: "The result was a block chain fork, with miners, merchants and users running the new version of Bitcoin accepting, and building on, that block, and miners, merchants and users running older versions of Bitcoin rejecting it and creating their own block chain."

Essentially, every Bitcoin miner has a computer attached to the Bitcoin network. According to ArsTechnica, a new cryptographic sequence for the creation of a Bitcoin is initiated approximately every 10 minutes. Bitcoin mining computers then race to complete the sequencing of the Bitcoin. To ensure that the coin goes to the winner, though, all of the Bitcoin-miners must run compatible software, which is precisely what did not happen Monday night.

The value of Bitcoins had shot-up since the end of February when the virtual currency was trading at around $32. The rapid rise in value was attributed to a decision by the world's largest Bitcoin exchange, Japan-based Mt. Gox, to run its U.S. operations through Seattle-baed CoinLab. CoinLab has a partnership with Silicon Valley Bank and has backing of around $500,000 from various venture capital funds, according to ArsTechnica.

"We're excited by, and awed at the responsibility we have caring for our over 100,000 new customers and over a half-billion dollars in annualized trade volume," CoinLab CEO Peter Vessenes said when the Mt. Gox deal was announced on Feb. 28. Barely two weeks later, the network-wide glitch once again demonstrated some of the inherent weaknesses in the growth of the Bitcoin market.

The Bitcoin market is completely unregulated and virtual currency presents a variety of unusual technical and theoretical problems. Beyond the somewhat arcane Bitcoin mining system and its propensity for technical glitches and bugs, Bitcoin has also been increasingly plagued by virtual heists. Because the currency is unregulated, security and backing for the currency are handled by individual brokers and exchanges that can vary widely in the quality and comprehensiveness of their security apparatus.

For instance, Bitcoin transaction service BitInstant was hacked at the end of February and experience close to four days of down-time. The hackers succeeded in stealing almost $12,500 of the virtual currency. The attack on BitInstant was carried out using social engineering techniques, and while the sum stolen may seem paltry, the fact that the theft could be carried out remotely and anonymously, emphasizes some of the weaknesses of the Bitcoin market.

BitInstant posted about the attack on its blog:

"The attacker contacted our domain registrar at Site5 posing as me and using a very similar email address as mine, they did so by proxying through a network owned by a haulage company in the UK whom I suspect are innocent victims the same as ourselves. Armed with knowledge of my place of birth and mother's maiden name alone (both facts easy to locate on the public record) they convinced Site5 staff to add their email address to the account and make it the primary login (this prevented us from deleting it from the account)."

A similar attack was carried out against the Bitfloor virtual currency exchange in Sept. 2012, this one exploiting an unencrypted back-up of the company's servers. The virtual bandits in that case made off 24,000 Bitcoins valued at the time at around $250,000.

In June, 2011, an anonymous Bitcoin user reported that they had over $500,000 of the virtual currency stolen from them, according to an FBI report.

The Bitcoin currency is popular precisely because it allows anonymous transactions outside of normal regulatory oversight. This anonymity, though, makes heists like that carried out on BitInstant much easier to carry out than a traditional bank robbery would be. Moreover, the anonymity of the Bitcoin shadow-world has caused many, including the FBI, to worry that the currency may become a vehicle for the funding of international terrorism or drug cartels.

The FBI published a 2012 report titled "Bitcoin Virtual Currency: Unique Features Present Distinct Challenges for Deterring Illicit Activity". According to the report, "Bitcoin ... provides a venue for individuals to generate, transfer, launder, and steal illicit funds with some anonymity. Bitcoin offers many of the same challenges associated with other virtual currencies ... and adds unique complexities for investigators because of its decentralized nature."

Already in June 2011, the Bitcoin currency was being used as the exclusive payment method on the online market place Silk Road, according to the FBI report. "Silk Road allowed parties to communicate anonymously for the purchase and sale of illegal goods, to include the purchase of illegal narcotics".

The report went on to surmise that the Bitcoin market could be used as a payment option for "cyber criminals" and a tool for money laundering. Moreover, according to the FBI "If Bitcoin stabilizes and grows in popularity, it will become an increasingly useful tool for various illegal activities beyond the cyber realm."

Essentially, the only thing right now keeping Bitcoin from becoming the currency of choice for illegal actors may be the technical problems which cause massive price fluctuations. If the market for Bitcoins stabilizes in a significant way, the FBI predicted in 2012, "Bitcoin might logically attract money launderers, human traffickers, terrorists, and other criminals who avoid traditional financial systems by using the Internet to conduct global monetary transfers."

Despite the previous night's technical glitches, Bitcoin prices surged back to $44.50 by midday Monday on CoinLab from their low of $37 during the height of the technical glitch.