Bitcoin was once considered to be a private digital currency used primarily by people on the dark web looking to buy and sell drugs. But most experts recognize that’s no longer the case. Illegal activity accounts for less than 1% of all Bitcoin transactions. It’s also become readily apparent that Bitcoin is not private. Bitcoin is pseudonymous, not anonymous, and Bitcoin is easily traceable. A much more contentious statement is that Bitcoin also lacks fungibility, one of the key properties of money.
Properties of Money
First, let’s go over what the fundamental properties of sound money are. Keep in mind in most cases it’s not an all or nothing distinction. There’s a scale.
- Unit of Account – A unit of measurement for tracking the underlying value of a good, service, or wealth. Currencies that are highly volatile relative to other currencies do not perform this function as well as more stable currencies since more volatile currencies need to keep changing the price to account for volatility.
- Durability – Lasts for long periods of time.
- Divisibility – Can be divided into smaller units.
- Portability – Easy to transport. While money does not need to be available in digital form, money available in digital form can be at an advantage here if managed correctly.
- Medium of Exchange – The value it holds can easily be exchanged for a good or service.
- Unforgeable – Not always included as one of the fundamental features, but obviously still important. Scarcity gives money value, and printing additional or fake money makes it less scarce. Without security features, money is easily duplicated.
- Fungibility – A key property of money whereby a given unit of value is interchangeable and equal in value to the same unit of value.
- Store of Value – Retains value and purchasing power over time (short-term, medium-term & long-term).
History of the Fungibility of Money
Money is fungible when its units are equal in value and interchangeable. If you have a $10 bill in your pocket, it should be the same value as any other $10 bill. And also the same value as two $5 bills. If you were to attempt to pay for a good at a merchant with a $10 bill and they said, “I’ll give you $9 (of value) for it”, it would not be fungible!
Fungibility of money is something we take for granted now because of the idea that some money might not be fungible sounds ridiculous at first. But the lack of fungibility of money used to be a very big issue. In the past when gold and silver coins were used, they often were composed of different purities. Older coins had higher gold/silver content in them, while newer coinage often had been ‘debased’ with cheaper metals like copper. People unsurprisingly preferred coinage with higher purity, as the scarcity of rarer metal is what gave it value. This is just one example but history is littered with examples of money lacking fungibility.
Modern Fiat Currency
Today, the fungibility of money isn’t discussed much because it’s usually not an issue. Cash, or more specifically, banknotes, are highly fungible. Banknotes are fungible because laws deem two banknotes of the same denomination to have the same value. People have no reason to assign different values to different banknotes anyway. They are just pieces of paper. Plus, banknotes can be hard to distinguish between one another; one needs to look carefully at the serial number in order to track banknotes, and no one really bothers to do that.
Fiat currency in digital form isn’t quite as fungible as physical banknotes, but generally speaking, it is still reasonably fungible. The main exception to its fungibility is when it’s used for illegal or fraudulent purposes. Recipients of digital fiat risk having the transaction reversed or currency seized in some cases even if they did nothing wrong themselves; the money is deemed to be ‘dirty’. This is why owners of ‘dirty’ money often seek to ‘clean’ their money, better known as ‘money laundering’. Once that money has been utilized and passed on to the next person, and the owner has received something of similar value in return, the funds are now ‘clean’. Digital fiat currency isn’t quite as fungible as cash. But because ‘dirty’ money can be seized or can cause problems for the owner, it’s often valued less than its face value.
Bitcoin’s Lack of Fungibility
Bitcoin has issues with fungibility due to how easily Bitcoin can be tracked. It’s more traceable than digital fiat currency and far more traceable than cash. Due to laws surrounding Anti-money Laundering (AML), exchanges often blacklist cryptocurrency that is ‘too closely’ linked to illegal or questionable sources. Exchanges often do this due to government laws or mandates requiring them to not facilitate the trading of ‘dirty’ money. Therefore, that Bitcoin is therefore worth nothing at that exchange or merchant. If you can find another person to trade it with, they might be willing to accept it albeit perhaps less than face value under the assumption they will either find a way to ‘clean’ it or be able to sell it somewhere else at its face value. Ultimately, some Bitcoin is valued less due to its ‘dirty’ history.
If you as a merchant happened to receive payment for a good or service that came from a ransomware hacker for example, and your exchange or service provider has that source address ‘blacklisted’, it shouldn’t be your responsibility to ensure it’s ‘good’ bitcoin. It wouldn’t be practical either for every individual to keep track of all the bad addresses as well as addresses that are ‘too closely linked’ to bad addresses either, and then cross-reference each transaction received before providing the good or service. But, for better or worse, that’s the situation we find ourselves in today. Bitcoin is lacking one of the key properties of money: Fungibility.
One of the main ways ‘dirty’ Bitcoin is tracked is through known ‘bad’ addresses, and then measuring how far any given wallet is away from said address. To ‘clean’ Bitcoin, some people create a variety of transactions, one after the other, so the illicit funds are more ‘hops’ away from the bad source(s). Other people elect to use a CoinJoin implementation, like the one implemented by Wasabi Wallet to obfuscate dirty history. Other people elect to not use Bitcoin at all and instead use ‘privacy coins’. These strategies work to varying degrees of effectiveness. Nonetheless, if you have to use such strategies in the first place for 1 BTC to be worth 1 BTC, the currency lacks fungibility!
The fungibility issue with Bitcoin exists because of laws requiring exchanges and businesses to avoid dealing with ‘dirty’ or tainted money. Such service providers follow local laws and take such actions accordingly, but compromise Bitcoin’s fungibility in the process. Bitcoin can be highly fungible just like cash. But unfortunately, that does not seem like the direction we are heading in. Rather, countries are heading in a direction of censorship, attacking transparent and traceable money in the process. These actions by governments are likely to push people to take measures that are even more resistant to censorship, less traceable, and more private. When that happens, governments will have a much tougher time fighting crime; they’ll be doing so blindfolded.