Lately there are more people asking or making statements about Bitcoin’s fungibility. Most probably by time a lot more people will turn their attention to this important topic. This is because fungibility is one of the essential characteristics of sound money. But what does fungible mean?
What Does Fungible Mean?
Fungibility is a term that is used in connection with assets like:
- money and
It means that the same good or assets can be interchanged for another of the same value.
So with money for example, you might decide to lend your friend €/$/£10 note. He can pay you back at a later date with another €/$/£10 note. Even though the note you gave him is not the same note he returned, the are exactly alike. Hence they have the same value.
On the other hand things that are non-fungible include cars, houses and original art like any Picasso painting or NFTs. These items cannot be exchanged for one another because they are not of equal value.
Even in the case of two houses side by side on the same street. They may have the same layout, but they are not identical. This is because of many reasons. One might be better kept than the other, the view might be different and so on.
Fungibility might sound like something superficial, but it is really important for sound money. This is because fungibility is partly what gives confidence in a currency.
Hence whether Bitcoin is fungible or not fungible is a big deal. To discuss Bitcoin’s fungibility further we first need to cover the basics of what makes sound money.
What Makes Sound Money?
According to the St Louis Fed apart from having 3 functions, money needs to have 6 characteristics. It needs to be:
- Divisible – You can make change
- Uniform – Each currency coin or note is of the same size and value as the next.
- Limited in supply – This goes hand in hand with functioning as a store of value. A money will maintain its value over time if its supply is limited.
- Acceptability – Other people will accept your payment in that particular currency.
Uniformity and acceptability are directly linked to fungibility. Different monies can have different amounts of soundness as if they are on a spectrum. The more in line with the 3 functions and 6 characteristics, the more sound it is.
You would expect fungibility from a currency as a given. So your friend can bring back any $10 note he likes to pay you back. Additionally you would expect that any currency should have fungibility.
Is Bitcoin Fungible?
With the assumption that any currency should be fungible then the same should apply to Bitcoin. Which would mean you should be able to exchange 1 Bitcoin for another.
However Bitcoin is becoming less fungible. This is because Bitcoin has one of the most transparent blockchains. Bitcoin is not anonymous, but public for everyone to see on the internet. To clarify, privacy and fungibility are interlinked.
Tainted Bitcoin coins include those that are used for:
- illegal deals,
- not generally government approved transactions or
- the coins mined used ‘dirty’ power sources like coal.
Examples of Bitcoin Fungibility Issues
There are a variety of different examples of Bitcoin’s non-fungibility. Some examples of Bitcoin’s lack of fungibility are listed in this article on Seth for Privacy.
As a side note, the website is promoting Monero as an alternative to Bitcoin. Precisely because Bitcoin is not fungible. However you should note that CipherTrace announced Monero tracing capabilities.
Back to Bitcoin; the point of sharing the website is because it lists examples of people that received ‘tainted’ Bitcoins. As a result they had their accounts flagged or frozen.
These examples of Bitcoin’s lack of fungibility happened on various platforms. For example with Wasabi wallets, Samourai wallets, in the JoinMarket and on exchanges.
One of the most known stories showing Bitcoin is not fungible is of the Bitfinex hack. The thieves that stole Bitcoin from the exchange were caught by law enforcement several years later.
It is true there are not that many examples of Bitcoin fungibility issues for now. However they all add up over time.
Bitcoin Non-Fungibility: Mixing Services
Some people had their deposits rejected on the services listed above due to mixing. To clarify, mixing services are used when someone does not want anyone to trace their transactions. So as not to link one wallet address with another.
However because everything is recorded in Bitcoin’s blockchain it is noticeable when someone used a mixing service. Law enforcement can check the blockchain for this activity.
They assume that if you have not done anything wrong you would not use a mixing service. So if you use one it’s a big red flag for them. In fact mixing is not legal in certain countries. Especially those that have KYC or know your customer and AML or Anti Money Laundering regulations in place.
Bitcoin Non-Fungibility: Virgin Coins
Additionally there is an issue with what is known as ‘Virgin Bitcoin’. Here is Kevin O’Leary’s interview on Kitco news talking about it. You can start watching from the 14:00 mark.
Virgin Bitcoin is Bitcoin mined in a sustainable way. Or Bitcoin that is originally mined by particular entities for one reason or another.
People in business like Kevin believe compliance is really important. This is because a lack of compliance can damage their reputation and business. Additionally individuals are keen to stay on the right side of the law also. This is because different entities can stop you from using your Bitcoin.
Subsequently it is why Kevin is advocating placing a wrapper around Bitcoins. Like that people can label them as sustainably mined coins. However Kevin recognises and openly admits in the video that it would take away fungibility.
Bitcoin Non-Fungibility: Blacklisted Addresses
Governments and authorities blacklist specific Bitcoin addresses. They are really accurate on which addresses they need to target. Additionally they revise their existing blacklist when required. After that they make sure to notify cryptocurrency services like exchanges to enforce the blacklist.
As a result it can kill any attempt for a blacklisted Bitcoin address to receive deposits. Additionally other Bitcoin addresses may not be able to receive funds from that wallet. Except by unsuspecting parties who are not aware they need to check whether the address has tainted coins.
So the funds are to an extent blocked in the wallet and worthless. That is to say unless that person or entity uses unregulated services and transacts with other blacklisted addresses. However at this point there are not that many blacklisted addresses so it is not much of a solution.
Moreover at times it is not controversial which addresses to blacklisted, but other times it is. Governments can blacklist addresses because they are used for illegal activities on the dark web.
Other times governments blacklist addresses for political purposes and these are usually controversial. This is because not everyone agrees with blacklisting particular entities in this way.
Filtering Out Tainted Bitcoins
Bitcoin that is ‘dirty’ is not accepted by exchanges, brokers and other crypto related businesses. On the other hand they are happy to pay a premium for virgin coins.
You can get clean Bitcoin from any regulated exchange. Hence you can put your mind to rest that this Bitcoin is accepted anywhere. However if you receive Bitcoin’s from any other service or directly from an individual you could have issues. Hence you may want to ensure you do not receive any tainted Bitcoins. Like that you will keep in line with AML regulations.
The technology behind wallets and surveying the blockchain has gotten more sophisticated. As a result you can block deposits that have used mixing services directly in your Bitcoin wallet.
Is Bitcoin Fungible: Why Is It a Big Deal?
When you read the fungibility graveyard list it can make you feel quite paranoid.
Say you decide to accept to receive a payment in Bitcoin without realising you can filter deposits. Then some time later you find out you received ‘tainted’ coins. Moreover you only find out because you got blocked out of your accounts. All of this out of no fault of your own.
Additionally as much as it sounds like a good solution, wrapping Bitcoins is a terrible idea. As a result the coins you bought or received beforehand could be worth less or even worthless.
In these cases one Bitcoin would not be equal to another Bitcoin. You should also be aware that institutions at times apply rules retroactively. So who is to say what government regulations might take issue with down the line.
Subsequently although it might sound nice to have transparency, it is good in particular situations. However it is Bitcoins Achilles heel. Bitcoin might become more of a surveillance coin. Companies and governments will know where you are spending your money and how much.
Is Bitcoin Fungible: Implementing Privacy
At the moment if you want more privacy when using Bitcoin you need to take care of a few things. According to Bitcoin.org you need to:
- Constantly create new wallet addresses. Like this you will not be associated with any address.
- Make sure you do not expose your wallet address and transactions publicly.
- You should not expose your IP address. Bitcoin.org suggest using the Tor browser. It can keep your IP address private.
- You should avoid using mixing services. There are two issues with using mixing services. Firstly the legal side as mentioned before. Its legality would depend on your jurisdiction. Secondly because mixing services are not great with large amounts of Bitcoin. Third parties can still trace larger values.
The problem with this is that everyone using the Bitcoin network has to do these steps. As a result it would make the whole system private. Otherwise it is still possible to track transactions and addresses.
However it is impossible to rely on everyone to know they need to do this. So this is not a good solution to the problem. Bitcoin needs a much better solution and ideally one that implements privacy by default.
Is Bitcoin Fungible: A Potential Solution
Bitcoin has had its issues in the past and it managed to overcome them. Like for example how it had issues with scalability where it could not support more than 7 transactions per second.
The developers put their heads together and came up with the Lightning Network. The network can support thousands of transactions per second. So developers could figure out a potential solution for Bitcoin’s fungibility problem.
In fact the developers are currently looking into increasing Bitcoin’s privacy. One potential solution to is to implement privacy protocols.
The solution has to be implemented well. That is to say we cannot end up with a situation like what happened to Litecoin.
The developers on Litecoin implemented a protocol for privacy called Mimblewimble. They implemented it on a side chain by means of a soft fork.
However privacy on Litecoin is not by default. You need to know what you are doing which is much like the situation now with Bitcoin. As a result the implementation was not a success.
Whatever solution the Bitcoin developers come up with needs to benefit the system and the Bitcoin community. The privacy protocol needs to group transactions together and only record the very basic information.
For example a cryptocurrency that does privacy well is Pirate Chain. It hides wallet addresses and transacting amounts. However it does it in a way where miners can still verify the transactions. Like this we can always be sure that the blockchain remains honest. Additionally confidence in the currency will never wain.
If this sort of protocol is implemented then Bitcoin can transition to becoming more of a private cryptocurrency. However this sort of implementation will need to be voted on by the miners. So it may take a while before it is implemented for Bitcoin.
Is Bitcoin Fungible: Final Thoughts
We want to switch from a fiat easy money system onto a sound money system. That would mean ditching all the problems inherent within easy money. We do not want to ditch it only to switch to something that is not the best alternative we can get.
Bitcoin’s fungibility is one of the reasons why Nassim Taleb has done a 180 and changed his mind on Bitcoin.
A lot of people are banking on Bitcoin as the solution. Bitcoin may work out. Perhaps some countries might wrap or label Bitcoin’s in some way. However maybe most will not and it will not matter.
I will finish off this article with a quote.
True sound money should protect civil liberties by limiting government power.Ludwig von Mises