Fungibility in Bitcoin
Fungibility is not untraceablity, it is transparency
What is fungibility?
Fungibility is viewed as the idea that every item in a set is worth exactly the same amount. In bitcoin, fungibility means that all bitcoins have the same value, regardless of who owns them or what their history is — and fungibility is extremely important to the success of a decentralized network.
The concern is that since the history of bitcoins can be tracked, merchants might refuse to accept bitcoins that have been ‘tainted’ in the past. This could be that the bitcoins were associated with drugs, gambling etc and can be traced back as the entire history is on the blockchain.
Fungibility is important for a currency because if merchants are scanning every coin’s history before accepting it as payment, that reduces trust in the currency. Coins that have a clean history will be accepted readily while coins that have been tainted would be trading at a discount. Every new exchange of currency is looked at with suspicion and is thoroughly scrutinized before accepting it. This drastically increases the friction of exchange and such a currency will never take off as the alternatives provide for a better form of money. Whatever medium of exchange provides the least amount of friction, ultimately becomes cash or money.
Since the launch of Bitcoin, there have been multiple projects to increase its fungibility to ultimately developing private cryptocurrencies such as Monero and Zcash. By ensuring that each coin is completely untrackeable, the proponents hope to ensure that no one can distinguish its past. However, this view is based on the misguided idea that decreasing traceablity increases fungibility.
Code is code
This idea follows the mindset that code is law. However, code is code and law is law. If you encounter a thief on the road, and he empties the cash you have on you, what do you do next? You go to a police station and inform them that your money has been stolen.
If the same thief swipes your phone and transfers your bitcoin from your wallet to his, would your response be any different?
Would you cheer that bitcoin is fungible and since code is code, these bitcoin have now become his? Would you marvel at the beauty of how now that these bitcoin have reached his address and since bitcoin are identical to all other bitcoin, the thief can spend your bitcoin. Luckily for us, this question isn’t a new one and has been answered through history.
History of Fungibility
Fungible goods are goods that are sold by weight or measure such as oil, sugar etc. We can term this as physical fungibility where one member of the population is completely swappable with another. For ex-one kilo of wheat can be swapped with another kilo of wheat of the same grade without causing any relative change . Gold has physical fungibility because it can be melted down completely and recasted into whatever form necessary without losing value. Fungibility is an important characteristic of money and precious metals such as gold that cannot be earmarked or differentiated would find more usage as money. This is because you don’t differentiate between a gold coin coming from a thief or a gold coin coming from the richest merchant in town. Both hold the same value in your eyes.
Once banknotes were introduced, this definition could no longer apply to them. Each banknote had an unique serial number and hence could be identified and tracked. Each note was completely distinguishable and if anyone tried to steal someone’s banknotes, the person who lost his notes could track them down using the serial numbers. There have been many such cases with but we will look at a particular case in 17th century England.
In the case of Miller v Race, the note in question had been issued by the Bank of England “to William Finney or bearer on demand” and subsequently mailed to a third party by Finney. Along the way it was stolen and used to buy room and board at an inn, the innkeeper Miller innocently accepting the note. Finney, upon learning of the robbery, asked Race, an employee at the Bank of England, to stop payment of the note, upon which Miller the innkeeper sued Race. If the bill was treated as a regular good, then Finney would have prevailed. However, the judge Mansfield ruled that despite the note having been stolen, Miller had the best title and was allowed to keep it. Lord Mansfield noted:
Banknotes are not goods, nor securities, nor documents for debts, nor are so esteemed; but are treated as money, as cash, in the ordinary course and transactions of business, by the general consent of mankind, which gives them the credit and currency of money to all intents and purposes. The are as much money as guineas themselves are, or any other current coins that is used in common payment as money or cash.
The judge ruled in such a fashion because otherwise, all forms of banknotes would lose their value and would not be used effectively. An insistence that each banknote would have to be scrutinized would paralyze the circulation of all paper money and effect commerce.
Fungibility through law
According to Henry Dunning Macleod’s Economics for Beginners:
When someone steals your property, your right to that property doesn’t transfer to the thief. You still retain the right to that property. You transfer the right to property in a voluntary exchange in return for something that you hold to be equivalent in value. Law is a necessity that allows voluntary contracts to flourish as it provides for legal recourse in case of any dispute.
Property in the money passes along with the honest possession in every sale or exchange. Good faith which came to be defined in the law of negotiable instruments as “honesty in fact whether negligent or otherwise.” Merchants do not need to scrutinize the currency even if it is through their negligence. As long as you accept currency in the normal course of business, the property in the currency will pass.
How can you prove that the right has passed to you in good faith? You would need proof of the exchange. The proof needs to include the sender and the recipient so that at any later point of time, if required, the merchant can prove the terms of the exchange. Without proof, good faith cannot be proven.
Privacy coins are abstract rights
Continuing from the book:
It is thus seen that in strict law the word Currency can only be applied to those Rights which are recorded on some material. An abstract Right cannot be lost, mislaid, stolen, and passed away in commerce. For a Right to be Currency in strict law it must be recorded on some material, so as to be capable of being carried in the hand, or put away in a drawer, or dropped in the street, and stolen from the drawer, or from a man’s pocket, and carried off by the finder or thief, and sold like a piece of goods.
Anonymous currencies like Zcash and Monero are trying to improve physical fungibility. They are trying to make the currency untrackeable and ensure that no one can differentiate different coins because the history cannot be seen. But they are abstract rights as they cannot be recorded. This will strike them away from ever being used as currency and also all forms of legal validity. Every exchange that involves a legal contract will never use an anonymous currency. These private currencies will have niche use cases but will never be part of the majority of usage as free trade requires rights to be written down in the presence of voluntary contracts.
Bitcoin is a pseudonomous currency. Every coin can be traced back to the genesis block. Each transaction consists of a signature proving the signer making this a recorded right and is recorded forever on the blockchain. A merchant who receives bitcoin can prove quite easily that the exchange was done in good faith.
Bitcoin as currency
If Bitcoin is classified as a currency and a thief stole your bitcoin, if the police nabbed the thief in time while he still had your bitcoin, you can still recover them. However, if he had exchanged them for goods to a merchant, then you cannot recover your bitcoin from the merchant. This is because the merchant has gotten the money in good faith. You will have the right to obtain back the stolen property from the thief and he will be forced to compensate in a different fashion.
When will bitcoin fall under such a categorization, the categorization of currency? Right now, it lacks ‘the general consent of mankind’ that the judge had ruled. But when used as cash by mankind, bitcoin will have the classification of currency stretched to it.
There are already precedents to this. In a case of SEC vs Shavers et al, the ruling stated that:
It is clear that Bitcoin can be used as money. It can be used to purchase goods or services, and used to pay for individual living expenses. The only limitation of Bitcoin is that it is limited to those places that accept it as currency. However, it can also be exchanged for conventional currencies, such as the US Dollar, Euro, Yen, and Yuan. Therefore, Bitcoin is a currency or form of money.
We should strive for Bitcoin to be termed as currency. We should embrace the legal construct of money and ensure that bitcoin is imbibed into the way the world works today. When the general public use Bitcoin as a medium of exchange, as cash, it becomes currency. And it carries the law along with it. Each transaction carries a history with it that can augment law as all contracts, all transactions are recorded on the blockchain. This leads to a case of minimizing friction and allowing businesses to accept bitcoin without worry. We should appreciate Satoshi’s design of bitcoin as he clearly understood the role of law in voluntary contracts and carefully created bitcoin such that it becomes the best form of money.