Crypto's Fungibility Problem by Alex Lielacher

This article explores the concept of fungibility, the connection to sound money and the implications for the future of the world's leading digital asset.

Defining fungibility

Economists do not agree on much. Different economic schools of thought hold distinct views as to what counts as money. The schism is most evident in the argument between the soundness of gold as opposed to fiat currency.

While economists do not always agree on what can be called money, they do agree on seven characteristics that a currency must possess to effectively facilitate the transfer of value. For a good or currency to function as a medium of exchange and be considered “sound money”, it must be durable, divisible, portable, uniform, acceptable, limited in supply and finally, fungible.

The majority of these characteristics are simple to understand. Durability refers to an item that can withstand continuous use by a large group of people. If money can be moved easily, it is portable. For money to be useful as a medium of exchange, it must be able to be split into smaller units, in other words, it must be divisible.

The final two characteristics are more polarizing amongst economists. For a good or currency to qualify as sound money, it must be limited in supply. This characteristic is imperative if money is to retain its value. Some items which have been utilized as money, such as gold, naturally possess this quality while others, like fiat currency, artificially create this scarcity through the banking system.

Fungibility is the property of a good or a commodity whose individual units are essentially interchangeable, and each of its parts is indistinguishable from another part. Fiat currency, unquestionably, possesses this feature. The ten-dollar bill in your pocket is acceptable everywhere regardless of its history. It does not matter if it once belonged to a criminal. Once the note makes its way to you, it is free from its historical transactions, dubious or not.

Crypto’s fungibility problem

Bitcoin, like most cryptocurrencies is backed by an underlying blockchain that is open and decentralized. The Bitcoin network, for example, is designed to broadcast the details associated with all transactions facilitated on its blockchain to anyone who participates within the ecosystem.

To preserve privacy, Bitcoin utilizes numerical addresses. Thus, in theory, it is relatively difficult to ascertain the real-world identity of those behind the transactions. Satoshi Nakamoto believed this would be enough to preserve the privacy and fungibility of Bitcoin.

He explained in the Bitcoin whitepaper: “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, the reality today is Bitcoin is not fungible. The rise of advanced blockchain analysis tools and chain-analysis firms means that it is now possible to trace the transaction history of bitcoins and other cryptocurrencies, and the individuals who use them.

The fungibility of the Bitcoin network began to be questioned as early as 2015 when a blockchain firm began to provide brand new bitcoins to its customers at a premium. Referred to as virgin bitcoin, these units of bitcoin are acquired directly from the miner and fetch a pretty penny as they are sold at a premium above current market prices. By buying freshly mined bitcoin, an investor can be assured that the bitcoin in question has no history as a payment on the dark web, or in a ransomware case, for example.

In early 2019, Litecoin creator Charlie Lee admitted that due to technological advancements, fungibility was lacking in both “digital gold” and “digital silver”. He tweeted: "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 disclosed that the Litecoin Foundation was focused on introducing Confidential Transactions to the digital currency. At the time, the announcement inspired excitement from many within the digital asset community because Litecoin is often considered as a testing ground for Bitcoin.

The announcement was made in January this year. Unfortunately, development on the Litecoin update has stalled, as a leaked internal chat revealed. Additionally, following the G20, the FATF has issued a new guideline, generally referred to as the ‘Travel Rule,’ which requires exchanges to disclose full details of all of the transactions they facilitate. However, virgin bitcoin, which has no transactional history, is considered exempt from this rule and is, thus, regulated differently.

A look into the future

While Lee has promised to refocus on bringing confidential transactions to the Litecoin network, this property won’t be implemented on the Bitcoin network anytime soon. However, there are other software updates that may help Bitcoin address its fungibility problem.

The first of these is Dandelion. Dandelion is a transaction privacy protocol that works by leveraging random pathways during the diffusion process following a transaction. Diffusion refers to the process by which the network relays transactional details to all of its nodes. The utilization of random pathways makes it harder to ascertain the true origin of the funds.

The earliest we can expect to see Dandelion go live on the Bitcoin network (through a soft fork) is in an estimated 12-18 months.

Another privacy protocol, called MimbleWimble, has proven to be robust following implementation in two privacy-centric altcoins. Despite its good track record, MW would require a hard fork to be implemented on the Bitcoin network and given the difficulty of reaching a consensus within the Bitcoin network, this will likely prove to be a challenge.

Finally, Schnorr Signatures are a scaling solution as they involve the collapse of transactional data, which would also mean that each block would be able to store more transactions. It also provides architectural support for further software updates which can introduce a greater level of privacy on the Bitcoin network. One such example is CoinJoin, which bundles together different transactions to protect the privacy of all the involved parties.

While fungibility still seems to be in the distant future for bitcoin, finding a solution for this challenge may be the final piece to the puzzle for bitcoin to become the sound money that Austrian economists have been longing for.