Bitfinex hack reveals centralization weakness

The bitcoin world has been rocked by another exchange hack, this time on the major Hong Kong exchange, Bitfinex. More than $70 million was snatched from user's wallets and as of now, the exchange has shut down all trading.

In the wake of this hack, bitcoin prices plummeted more than $100 from a comfortable $650 to around $550. Exchange hacking is a fairly common occurrence, but the increasing centralization of bitcoin makes it even more damaging.

Bitcoin was created out of an ideology of decentralization: If no government controlled it, then it would be a truly "free" currency. But, bitcoin ownership is now concentrated in a few massive exchanges. These charts from bitcoincharts.com demonstrate the scope of the problem:

Currently, okcoin holds approximately 80 percent of the bitcoin market, and btcn holds approximately 11 percent of the market. These exchanges comprise the massive Chinese market, which represents 91 percent of all bitcoin ownership. On the U.S. side, five exchanges hold sway, but one, Bitfinex, holds around 50 percent of market share.

By its nature, bitcoin is a volatile currency. And with bitcoin holdings concentrated in such a small number of exchanges, one hack can have major repercussions.

Consider the example of Mt. Gox: At its height in 2014, Mt. Gox handled 70 percent of all bitcoin transactions. However, when it lost 850,000 bitcoins in a single alleged hack, the value of bitcoin plummeted 21 percent.

Bitcoin has so far bounced back from exchange-hacking fiascos. But the question remains: Is it really wise to have a small number of exchanges hold the massive amounts of bitcoin when they have proven again and again to be vulnerable to hacking?

This question becomes even more urgent considering that some exchanges engage in questionable business practices. For example, the U.S. Commodity Futures Trading Commission fined Bitfinex $75,000 in June for "illegal off-exchange financed retail commodity transactions." In other words, the exchange allowed users to lend money to other users but kept the money in its own deposit wallets.

For a more extreme example, the former CEO of Mt. Gox, Mark Karpeles was arrested in August 2015 on suspicion of manipulating company funds to seize millions of dollars in bitcoin.

According to Ray Valdes, a Gartner analyst, the issue is not with bitcoin itself but, rather, with the exchanges and their third-party software platforms. Either the software is poorly programmed, or the exchange operators themselves have criminal element looking to defraud users.

With each hack and scam, bitcoin's name is tarnished and its value drops dramatically. It is time to consider decentralization of exchange holdings as a way to mitigate disasters and encourage innovation.