Bitcoin Redux explains what’s going wrong in the world of cryptocurrencies. The bitcoin exchanges are developing into a shadow banking system, which do not give their customers actual bitcoin but rather display a “balance” and allow them to transact with others. However if Alice sends Bob a bitcoin, and they’re both customers of the same exchange, it just adjusts their balances rather than doing anything on the blockchain. This is an e-money service, according to European law, but is the law enforced? Not where it matters. We’ve been looking at the details.

In March we wrote about how to trace stolen bitcoin, describing new tools that enable us to track crime proceeds on the blockchain with more precision than before. We waited for victims of bitcoin theft and fraud to come to us, so we could test our tools on real cases. However in most of them it was not clear that the victims had ever owned any bitcoin at all.

There are basically three ways you could try to hold a bitcoin. You could buy one from an exchange and get them to send it to a wallet you host yourself, but almost nobody does that.

You could buy one from an exchange and get the exchange to keep the keys for you, so that the asset was unique to you and they were only guarding it for you – just like when you buy gold and the bullion merchant then charges you a fee to guard your gold in his vault. If the merchant goes bust, you can turn up at the vault with your receipt and demand your gold back.

Or you could buy one from an exchange and have them owe you a bitcoin – just as when you put your money in the bank. The bank doesn’t have a stack of banknotes in the vault with your name on it; and if it goes bust you have to stand in line with the other creditors.

It seems that most people who buy bitcoin think that they’re operating under the gold merchant model, while most exchanges operate under the bank model. This raises a whole host of issues around solvency, liquidity, accounting practices, money laundering, risk and trust. The details matter, and the more we look at them, the worse it seems.

This paper will appear at the Workshop on the Economics of Information Security later this month. It contains eight recommendations for what governments should be doing to clean up this mess.