bitcoin collapseThe Bitcoin market is in a frenzy, and for good reason. With market confidence waning and an uncertain future for the digital currency, many are wondering if a Bitcoin collapse is imminent.

I wrote about Bitcoin a couple weeks ago, explaining the structure of the virtual currency and also laying out reasons to avoid investing in Bitcoin.

Even in those short weeks, the Bitcoin market has changed dramatically.

MtGox, once the world’s largest Bitcoin exchange, stunned the market by shutting its doors earlier this week.

On February 23 the CEO of MtGox resigned from the board of the Bitcoin foundation – a non-profit organization seeking to protect and advance Bitcoin – and all posts from the MtGox Twitter (NYSE: TWTR) account were deleted the same day.

The next day, February 24, MtGox suspended Bitcoin trading. The website went offline soon after.

Details surrounding the demise of MtGox remain hazy. However a widely cited Bitcoin blogger published a document believed to be an internal MtGox memo that paints a dark picture.

The document, which has been cited by the New York Times, suggests that a massive theft of Bitcoins occurred over several years through the MtGox exchange and that the company is now insolvent. If true, roughly 6% of all Bitcoins in circulation are missing, a digital heist worth over $400 million at today’s Bitcoin values.

If true, it suggests that the very foundation on which Bitcoin was built and is supposedly secure has inherent flaws.

This seems bad. But it gets worse.

The Possibility of a Bitcoin Collapse

The Bitcoin network relies on a volunteer network of computers to facilitate transactions. This process, called “mining,” offers an incentive to users willing to give computing power to the Bitcoin network. When they complete a certain amount of work for the Bitcoin network they are rewarded with new “blocks” of Bitcoins.

Basically, Bitcoin miners spend money on electricity and computer hardware and are rewarded with Bitcoins. Assuming the Bitcoin reward covers the miner’s costs, there will always be enough users willing to mine to keep the Bitcoin network functioning.

But what if the Bitcoin reward isn’t significant enough to keep miners interested?

That’s exactly what one expert is predicting. After running financial analysis on the costs of mining for Bitcoin, financial expert Peter Leeds believes that the price of Bitcoin needs to remain above $350 for miners to make money.

If a bunch of miners quit, Bitcoin transactions will take much longer to complete.

If all miners quit, Bitcoin users wouldn’t be able to make transactions at all and Bitcoin would effectively end.

Is this a realistic possibility?

Bitcoin prices fell from over $550 to below $450 between February 24 and 25. Today, prices have recovered to around $570. Such volatility can be explained by a loss of confidence resulting from the collapse of MtGox.

We still don’t know details of MtGox’s rapid demise, but reports allege the loss or theft of over $400 million worth of the supposedly impenetrable virtual currency.

If MtGox’s demise turns out to be the result of a flaw in the structure of Bitcoin, the loss of confidence would dwarf what occurred between February 24 and 25. And if the price of Bitcoin drops below a level that makes mining for Bitcoin profitable, we could very well see a Bitcoin collapse.

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