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Is Bitcoin Headed for a Break in Fungibility?

Op-ed - Is Bitcoin Headed for a Break in Fungibility?

Fungibility is often held as a crucial characteristic of sound money. But what happens when money has a public record of every transaction, and morally questionable trades can be identified? Is bitcoin headed for a break in fungibility?

The debate about whether Bitcoin is fit to be a currency rather than a payment layer between currencies is as alive as it has ever been. Many of these tensions about what Bitcoin is or should be have been aired and discussed during the blocksize debate and are ongoing.

One essential element of a money which has not particularly been illustrated is how bitcoin might be affected by a significant gap in its “fungibility.” 

“[Fungibility] is the idea that a 10 dollar note is the same as any other 10 dollar note. So if you receive a note that was involved in a theft 10 transactions go and the police investigated the theft, then they would have no right to take the note away from you,” according to Adam Back, the inventor of Hashcash.

According to Back, this is an old legal concept, often traced to a 17th century court case in Scotland. In that case, a pair of high value notes marked with a unique signature were stolen and later on turned up at a bank. The owner took the case to court in an attempt to have the bank return the notes to him. The courts ruled that “if notes could be returned to a previous owner after a theft, it could erode confidence in a currency,” since your ownership would be at question and you would have to go and check the newspapers or try to make sure your money has not been claimed as stolen.

While the above briefly illuminates the history of fungibility as a key characteristic to money, it still leaves questions about what might actually happen to a currency if such a crack in fungibility appeared. Kristov Atlas, a bitcoin privacy researcher raised some questions about the importance of fungibility in a recent post saying:

The needs for fungibility are somewhat unclear, in my opinion. Privacy advocates have been talking up fungibility for a while without providing a lot of evidence to back it. Perhaps this is why it has made such a dull impression on people.

Fungibility is a particular concern for bitcoin because bitcoin, unlike cash, sea shells or silver coins, has a cryptographically provable history of ownership. If the identity of a particular bitcoin’s previous owners or the nature of the transactions they engaged in was to be revealed and deemed illegal, could this cause a future where new or unspent ‘virgin’ bitcoins are worth much more than old bitcoins orwhere coins associated with Silk Road transactions lose a great deal of their value?

Such a scenario is not far-fetched. There are various blockchain analytics and compliance companies such as Coinalytics

and Chainanalysis
which claim to be using artificial intelligence algorithms to group addresses and transactions and thus reveal ‘entities’ in the network. It’s not hard to imagine that someday bitcoin payment processors could automatically compare incoming bitcoins to a “dirty coin” database, to determine their legality and or past connection with illegal trade.

To learn more about these questions and concerns, Bitcoin Magazine
spoke with J.P. Koning, an economics blogger

with a substantial body of work on the history of money.

Do you know any examples in history where the fungibility of a currency broke? How did that play out?

Many of the problems faced by those who managed medieval monetary system can be traced to deficits in fungibility.

For instance, England's silver pennies degraded steadily over time through regular wear and tear and also as they were clipp'd and sweated. When the mint issued new full bodied pennies, questions of fungibility emerged. A new penny, after all, had much more silver than a worn penny, and therefore had more intrinsic value. But each were pennies; they both had the same face value. So just as you get good and bad bitcoin, you had good and bad pennies.

The medieval economy dealt with the fungibility problem in a unique way. According to law and custom, merchants accepted all coins at face value. Put differently, they did not differentiate between old and new pennies. Shoppers thus had an incentive to pay with old and degraded pennies rather than use new full-bodied pennies. Why buy a fish with 24 grams of silver when you can pay with just 23 grams? Thus the bad money drove out the good from circulation; this is Gresham's famous law. For centuries, only the worst pennies circulated in England.

In the case of bitcoin, I'm not sure that law or custom would require merchants to accept all bitcoin at the same rate. If they were to differentiate between the two, you'd most likely get the opposite effect; good money would drive out the bad.”

Are you worried about a scenario where bitcoins with close association with a bitcoin address used on the Silk Road are flagged as being high risk for money laundering? What is the worse that could happen to bitcoin in the above scenario?

That reminds me of the recent euro crisis, where various types of euros threatened to become non-fungible with others. This summer, for instance, Greek euro deposits certainly lost their equivalence to non-Greek euros.

Koning expanded on this thought in a related article, where he wrote:

One of the deep problems facing the euro over the last three years was fear of euro break up. If Greece decided to leave the euro (or was kicked out), a Greek euro would no longer be equal to a German one. In the mind of the markets, euros had ceased to be homogeneous.

In anticipation of potential break up, a tremendous bank run began in which massive amounts of Italian, Greek, Irish, Spanish, and Portuguese euro deposits were converted into German and Dutch euro deposits. This all occurred on the books of the ECB's intra-eurosystem clearing mechanism—Target2. While no limits had ever been placed on Target2 balances (or imbalances), fears that Germans might revolt and try to close the Target2 window led to ever faster withdrawals from the GIIPS.

Bitcoin in some ways is very different than cash, particularly because the identification of each coin is tied to a historical public record of every transaction. I wonder if you know of any examples where such a financial asset suffered from a gap in fungibility. Like the stock of a company, or any other ownership token that would have a transparent history of ownership.

Bills of exchange and chopmarked

coins also had a paper trail. In the case of bills of exchange, the moment that the credit worthiness of a certain cosignatory to a bill of exchange was doubted, it would have started to trade at a much larger discount to par.

Analog versus Digital Money

Koning’s historical insights do paint a picture into how the market might evolve as money’s fungibility changes, but bitcoin is unique and may evolve differently than any money before it.

Many of Koning’s examples were related to a break in fungibility for political reasons, such as the euro crisis which saw runs on banks and demand for more trusted government versions of the euro versus the euros in Greek banks. However, Bitcoin’s fungibility might be threatened by its use in dark markets.

It is no secret that bitcoin has been widely used online to purchase goods on dark markets such as the Silk Road. A report

by Kyle Soska and Nicolas Christin from Carnegie Mellon University claims that dark markets had a higher daily bitcoin trade volume than BitPay’s reported $435,000 daily average, in 2014.

"In the short four years since the development of the original Silk Road, total volumes have reached up to $650,000 daily (averaged over 30-day windows) and are generally stable around $300,000–$500,000 a day, far exceeding what had been previously reported," said the report.

Virgin Coins and Bitcoin’s Fungibility

To learn about the demand for newly mined, unspent “virgin” Bitcoins, Bitcoin Magazine
spoke with FinTech consultant Bilal Dar. According to Dar, he’s seen “virgin” bitcoin trading at a 20 percent to 30 percent premium to market prices. 

The demand for virgin was nothing new ... Having virgin coins had many benefits. A full block of 25 coins mined between 2012 to 2016 would have collectible value. Similar is the value for 50 BTC block ... there are ways of deferring taxes if you have a coin with no or least amount of history. [Though some of this] would require private key swapping and a 'substantial' amount of trust between parties conducting transaction.

So did the value of Virgin coins have anything to do with the possibility of older coins being 'dirty'? No ... It was more of a possibility of 'perceived value' ... People had a lack of understanding, and in some case genuine use cases.

Today he claims that the demand for virgin coins remains, but the supply has increased dramatically. “You can wait for 2 weeks and batches of freshly minted coin from China would be available,” said Dar.

The Foreseeable Future

The impact of a privacy leak or fungibility weakness in Bitcoin is yet to be discovered. After all, a cryptographically provable history of every transaction is an essential part Bitcoin and the blockchain. The good news is that this topic is in the mind of many Bitcoin core developers and pioneers such as Adam Back, Gregory Maxwell and many others.

In a 2014 presentation, Back explained the functionality of something called Blind RSA transactions dating back to the days of digicash, which according to him, are

“cryptographically unlinkable" and
"payer anonymous.” Another promising discussion may be something called Confidential Transactions, being developed by several core developers at Blockstream

And of course, many alternative cryptocurrencies have worked on the issue for years, including DASH, Monero, Cryptonote, and Zerocash. How Bitcoin will adapt to this market environment and whether it will evolve beyond this threat to its fungibility remains to be seen.