Banking

An Online Black Market Vanishes. What Took So Long?

The mystery of AlphaBay has revealed one interesting development: Darknet markets are getting into the banking business.

The art of diversification.

Photographer: Roslan Rahman/AFP/Getty Images

Last Tuesday, the darknet market known as AlphaBay vanished without a trace. With more than 100,000 users and an estimated $800,000 in daily transactions, it was the largest market in the underground web. AlphaBay administrators initially appeared on Reddit to assure users that the site was undergoing routine maintenance, but with each passing day, the story seemed less and less plausible. Now that more than a week has elapsed, it looks like AlphaBay may have pulled the ultimate exit scam.

Darknet markets are hidden websites accessible through browsers such as Tor, which route encrypted communications through multiple machines to mask the user’s location. Each site hosts a unique selection of vendors peddling illicit goods such as drugs, weapons and stolen data. Darknet participants are not exactly beacons of trust, so sites like AlphaBay offer an escrow service to hold bitcoin payments until a buyer confirms receipt of a delivery. Market operators typically charge a 5-10 percent fee per transaction.

The escrow service creates a separate risk to the vendors: The larger the marketplace, the greater the amount of bitcoin in custody at any given time. A sizable market might be holding several million dollars' worth of bitcoin in escrow, and vendors have to trust the site administrators not to shut it all down and run off with the deposits -- a move known as an exit scam. Two years ago, a market called Evolution exited with an estimated $12 million worth of bitcoin.

It’s not a question of whether exit scams will occur; rather, it’s a question of when. The anonymous nature of these sites means that participants have no recourse in the event of wrongdoing. Market operators have to calculate the optimal time for retirement, balancing their profits against the risk of a hack or police raid. Underground markets tend to have a short lifespan.

Exit scams are as old as the warehousing profession. In the 1640s, the outbreak of the English Civil War drew merchants’ apprentices to join the army, leaving merchants with no one to safeguard their surplus cash. The merchants turned to private goldsmiths, who were accustomed to safekeeping precious metals. Initially, there were reports of the goldsmiths packing up and skipping town, but the enterprising goldsmiths eventually discovered that profits could be maximized not by going on the lam, but by sticking around and issuing warehouse receipts in excess of the gold on hand. And thus fractional reserve banking was born. 1

The remarkable thing about AlphaBay is not its recent disappearance, but the fact that it apparently managed to grow so large without succumbing to insider theft. This can be attributed, in part, to its unique business model. Earlier this year, a site administrator explained that AlphaBay was not actually in the business of e-commerce:

You can see Alphabay like a bank: while we allow people to deposit and withdraw at will, drugs are merely a product to attract customer. The cold wallet coins aren't just standing there: we invest in various things anonymously, make money with those investments, while always ensuring to run at 100% reserve.

So AlphaBay is really a deposit bank! Whereas my credit union attracts customers with offers of 0.01 percent interest and a free pen, AlphaBay offers access to illegal drugs. It’s unclear how they manage to simultaneously invest customer demand deposits while maintaining a full reserve -- the numerous complaints of suspended withdrawals suggest that they don’t.

Bitcoin enthusiasts tend to take a dim view of fractional reserve banking. Past situations involving an overissue of bitcoin-based debt instruments resulted in massive implosions, most notably the collapse of Mt. Gox. We may never learn the true fate of AlphaBay; the underground web is littered with black markets that disappeared with no further explanation. But it’s surely a testament to Bitcoin’s price stability that darknet markets have transitioned to the business of banking.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

  1. See J. Milnes Holden's "The History of Negotiable Instruments in English Law" (1955). 

To contact the author of this story:
Elaine Ou at elaine@globalfinancialaccess.com

To contact the editor responsible for this story:
Tracy Walsh at twalsh67@bloomberg.net

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