Why is the general fungibility of cryptocurrency units becoming a major concern?
Cryptocurrency thrives on its reputation of being a flawless new system in the field of finance. One such quality that it is popular for is its inherent anonymity. This, among others, is an element that is making digital currency as prominent in the public eye as it is.
One such crypto that boasts this anonymous aspect is Bitcoin. Being the first big-name cryptocurrency, it is also the most popular. Even those unaware of the mechanics of digital currencies know of Bitcoin. Its inception would result in allowing distributed online value transfer for the very first time. There is no longer a requirement for people to rely on a third party to move money on the Internet. This means they are safe from third parties that could be corrupt or even incompetent.
As impressive as it is, Bitcoin is not perfect. What’s keeping it from achieving perfection relates to anonymity, or lack thereof.
In fact, it is not just Bitcoin. Cryptocurrency as a whole has an overarching problem that is preventing it from being “perfect.” This problem ties into the ‘fungibility’ of these digital assets. This article will dive further into this issue, as well as explain what this concept pertains to.
What does Fungibility mean?
‘Fungibility’ is a term that will come up frequently when you are reading about certain assets. It refers to the general ability of a good or asset to be interchangeable with other individual goods or assets. Specifically, those of the same type. Fungible assets help simplify the exchange and trade processes because the concept of fungibility implies equal value between the assets.
Fungibility is indicative of two things being identical in specification, where individual units can undergo mutual substitution. For example, specific grades of commodities, like No. 2 yellow corn, are fungible. The reason is due to the location of the corn’s growth being insignificant. All corn that is described as No. 2 yellow corn is worth the exact same amount. Other fungible commodities include sweet crude oil, company shares, bonds, currencies, and an array of precious metals.
Cross-listed stocks are also considered fungible. These are identical shares of stock that are listed on the home country exchange, as well as multiple global exchanges. The shares are representative of the same ownership interest in a firm. This is regardless of whether purchasing them was on the New York Stock Exchange or the Tokyo Stock Exchange.
Most of the time, finance is what fungibility associates with. However, it is easy to find it in other disciplines, such as quantum physics. Oxford theoretical physicist, David Deutsch, uses the term ‘fungible’ to describe the physical nature of quantum particles. It also describes universes existing within the quantum multiverse. By virtue of being identical in all respects, they are where a variety of particles chaotically divide or combine. This is the direct result of physical interactions from a common fungible fund in superposition.
An additional example of what a fungible asset could be is money. Suppose Person A lends Person B a $50 bill. In this case, it does not matter to Person A if they receive a reimbursement with a different $50 bill. This is because it is mutually substitutable. In this sense, Person A’s reimbursement can be with two $20 bills and one $10 bill and it will still be satisfactory. It will equal out to $50 in the end, so it doesn’t matter.
But what about ‘non-fungibility’?
An example of this would be if Person A lends Person B their car. Unlike with money, it is not acceptable – nor does it make sense – for Person B to return a different car. This is regardless if it is the same make and model as the car that Person A was lending them. Cars are not fungible with respect to ownership. The gasoline that powers the cars, however, is fungible.
The line between fungibility and non-fungibility is a thin one. Gold is generally seen as fungible (one gold ounce equates to another gold ounce), though there are cases that say otherwise.
The Federal Reserve Bank of New York provides gold custody services to central banks and governments across the globe. They do so by storing gold bars into its underground vault. Weighing all of the gold bars within the vault is done with precision. The refiner and purity markings on each bar undergo inspection to confirm that they match the depositor instruction sheets. There is careful monitoring and recording of this process. The bars that are deposited to the New York Fed are the same ones that return upon withdrawal. Because of this, these types of gold deposits are not in any way fungible.
The characteristics of “sound money”
Economists do not typically agree on what can officially be “money.” They do, however, agree on one particular thing. That being the seven characteristics that a currency needs to possess in order to effectively facilitate the transfer of value. For a good or currency to function as an exchange medium and be ‘sound money’, it must be:
- Limited in supply
The bulk of these characteristics are quite straightforward and easy to understand. Durability means that an item is able to endure continuous use by a large group. If it isn’t difficult to move money, then it is portable. In order for money to be useful as an exchange medium, it needs to be capable of splitting into smaller units. Put simply, it must be divisible.
The last two characteristics (“Limited in supply” and “Fungible”) are very polarizing among economists. For a good or currency to qualify, it needs to have a limit in its supply. This characteristic is a crucial one if money wants to retain its overall value. There are some items that are frequently used as money, such as gold, that naturally possess this quality. Meanwhile, there are others, like fiat currency, that artificially create this scarcity by way of the banking system.
At its core, fungibility is the property of a good or a commodity whose individual units are basically interchangeable. Moreover, each of its parts are identical to another part. Undoubtedly, fiat currency possesses this specific feature.
So, what’s the problem?
Bitcoin, like a lot of cryptocurrencies, garners backing from an underlying blockchain. This blockchain is open-source, as well as decentralized. A notable example would be the Bitcoin network. Its design allows it to broadcast the details that associate with all transactions that the blockchain facilitates to participants within the ecosystem.
To preserve this element of privacy, Bitcoin utilizes numerical addresses. Theoretically speaking, it is difficult to determine the real-world identities of those who are responsible for the transactions. The mysterious figure, Satoshi Nakamoto, believes that this would be enough to maintain Bitcoin’s privacy and fungibility.
In the Bitcoin whitepaper, he explains that:
“The traditional banking model achieves a level of privacy by limiting access to information to the parties involved and the trusted third party. The necessity to announce all transactions publicly precludes this method, but privacy can still be maintained by breaking the flow of information in another place: by keeping public keys anonymous.”
Unfortunately, as it has been touched upon earlier, the reality is quite different. Not only is Bitcoin not as anonymous as it claims, it is also not fungible. The rise of complex blockchain analysis tools and chain-analysis firms means the start of something new. That being it is possible to trace the transaction history of bitcoins and other cryptocurrencies. This also extends to the individuals who use them.
The start of questioning the fungibility of the Bitcoin network was as early as 2015. During this time, BlockTrail’s Mint service would provide new bitcoins to its customers at a premium. With many referring to it as ‘virgin bitcoin’, acquiring these units are done directly from the miner. Furthermore, they make a considerable amount of money because the selling price is at a premium above current market prices. By purchasing bitcoin that was recently mined, an investor can take comfort in knowing that the bitcoin has no history as dark web payment.
During the early months of 2019, Litecoin creator, Charlie Lee, admits something pertaining to technological advancements. He claims that fungibility was lacking in both “digital gold” and “digital silver”. He would later tweet the following:
“Fungibility is the only property of sound money that is missing from Bitcoin & Litecoin. Now that the scaling debate is behind us, the next battleground will be on fungibility and privacy.”
Lee discloses that the focus of the Litecoin Foundation was on introducing the Confidential Transactions concept to the digital currency. At the time, the announcement provoked a sense of excitement from many people in the digital asset community. This is mainly because a lot of people see Litecoin as a testing ground for Bitcoin.
The general fungibility of cryptocurrency units is becoming a major concern. Especially when you take into consideration that blockchain analysis firms are succeeding in uncovering the identities of those behind suspicious addresses.
Blockchain analysis is vital in terms of scenarios where criminal activity is suspected. What’s more, the findings draw from tracking that the units use in the nefarious activity. Take an exchange hack, for example. Blockchain analysis will likely take place to identify who is the owner of a wallet address that receives stolen coins.
Blockchain analysis reports will sometimes be capable of identifying an individual responsible for conducting criminal activity. However, the reports may also lead to the branding of the coins that are commonplace in these transactions as ‘tainted’.
There is a particularly good way to think about this. It doesn’t matter to you if the fiat currency you own that the bank issues was once in the possession of a famous actor. Alternatively, it doesn’t matter if a more infamous figure was its owner at one point. Ultimately, the previous holders of the note do not have an effect on your ability to use the currency. Nor does it affect a provider’s willingness to accept the note as payment in exchange for goods or services.
Oftentimes, banks try to destroy this fungibility. A popular method is putting exploding dye packs in cash that is stolen during a bank robbery. If the pack goes off, the colourful dye will cover the cash, thus making it unspendable.
On an array of networks, like Bitcoin and Litecoin, you are able to view the history of every unit spent. Because of this, coins that are stolen during, say, an exchange hack are identifiable/ There are many members of the cryptocurrency community that are actively trying to avoid this ‘tainted’ currency. As a matter of fact, the undesirable nature of tainted coins would result in the rise of a specific market. Where miners are able to sell brand new bitcoin units, but only at a premium.
Various other methods that are working towards the mitigation of this emerging challenge include the creation of a whitelist. This is a complete list of coins whose history was once under heavy scrutiny.
These are indeed very interesting responses to the problem. Be that as it may, it is not unorthodox to view them as being design challenges. Suppose networks are able to find a way to conceal the amounts and other aspects of transactions. Moreover, they can do so while retaining the other features inherent to their blockchains. And without ever putting the security of the network in jeopardy. In this particular case, the challenge will be invalidated.
Lee is of the belief that fungibility is essentially an architectural issue. For that matter, he appears to view Confidential Transactions as the tool that can be achieveable on the Litecoin Network.
In the same tweet referenced earlier, he makes the following statement:
“I am now focused on making Litecoin more fungible by adding Confidential Transactions.”
It’s clear to see that widespread fungibility remains a goal that will take a while to achieve. When it comes to crypto, it is in the distant future. Nevertheless, finding a solution for this challenge could aid in cryptocurrency becoming sound money.