Thursday , June 24 2021
Home / Mises Institute /Why Fungibility Is Important in Understanding Money and Crypto

Why Fungibility Is Important in Understanding Money and Crypto

Summary:
As the decentralized revolution gains momentum and cryptocurrency adoption reaches new heights, concerns pertaining to the quality of money are too often ignored. According to a Crypto.com report, the number of bitcoin owners surpassed 71 million in January 2021, but how many of them are aware that bitcoin is not anonymous but rather pseudonymous, or recognize the pitfalls of embracing a currency lacking fungibility? While bitcoin’s provable scarcity signifies a return to the tenets of sound money, its creator’s peer-to-peer vision ultimately falls short without fungibility, because counterparty risk is created. Bitcoin’s fungibility issues come from the history that is attached to the coins. The insertion of trust into transactions by scrutinizing coin history has the potential to

Topics:
Mises Institute considers the following as important:

This could be interesting, too:

Mises Institute writes How Fiat Money Changes Culture

Jay Taylor writes The Outlook for U.S. Stocks?

Mises Institute writes The Road to Authoritarianism is Paved with Fiat Currency

Mises Institute writes An Antidote to Political Correctness in Schools: Just Walk Away

As the decentralized revolution gains momentum and cryptocurrency adoption reaches new heights, concerns pertaining to the quality of money are too often ignored. According to a Crypto.com report, the number of bitcoin owners surpassed 71 million in January 2021, but how many of them are aware that bitcoin is not anonymous but rather pseudonymous, or recognize the pitfalls of embracing a currency lacking fungibility? While bitcoin’s provable scarcity signifies a return to the tenets of sound money, its creator’s peer-to-peer vision ultimately falls short without fungibility, because counterparty risk is created. Bitcoin’s fungibility issues come from the history that is attached to the coins. The insertion of trust into transactions by scrutinizing coin history has the potential to splinter the bitcoin network, in the process increasing fees as a result of regulatory compliance costs. More alarmingly, a transparent blockchain inevitably transforms into a surveillance chain on which reputation travels. In order to prevent censorship and protect our natural rights to privacy, a fungible currency is not a luxury, but a requirement.

Money facilitates business on the market by serving as a medium of exchange, store of value, and a unit of account. The Federal Reserve Bank of St. Louis lists six characteristics of money: durability, portability, divisibility, limited supply, uniformity, and acceptability. The latter two of these attributes are directly impacted by a currency’s fungibility.

Fungible assets at their core are interchangeable. On the nonfungible end of the spectrum are fundamentally unique assets such as real estate and artwork. Conversely, precious metals represent physical fungible assets. Gold, for example, can be melted down and swapped without complication. As noted by Menger (1892), the adoption of gold and silver as forms of money throughout history can be partially attributed to the homogeneity of these materials. In order to satisfy Berg’s (2020) fungibility criteria, “each unit of a currency, or any commodity used in a money function, should be indistinguishable from others of the same denomination,” and “an individual unit of said currency should not be reidentifiable through time and change.”

The most widely adopted digital decentralized assets designed to serve as money are bitcoin (BTC), litecoin (LTC), and bitcoin cash (BCH). All of these cryptocurrencies, however, are nonfungible in nature. Each satoshi, the smallest BTC unit, possesses an accessible history on the network’s transparent ledger. Consequently, 1 BTC ? 1 BTC.

Imagine selling an automobile you posted on Craigslist to a stranger who, unbeknownst to you, earned their fortune peddling contraband on the dark web. Subsequently, you attempt to deposit the proceeds of the sale, but to your surprise, your financial institution has flagged the transaction and will not accept your “tainted” bitcoin.

According to Mises (1953), “the subjective use-value of money, which coincides with its subjective exchange value, is nothing but the anticipated use-value of the things that are to be bought with it.” Economic calculations become increasingly difficult when ambiguity pervades the medium of exchange. Fungible monies maintain their purchasing power regardless of past use, thus eliminating uncertainty associated with future use. A transacting party’s faith that their money will be accepted by future counterparties ultimately is shaken without fungibility. If we go back to our Craigslist example, the automobile owner would be wise to either require additional information from the buyer or to increase the sale price to offset the risk of not being able to satisfy anticipated value propositions.

The long-term implication of this problem for bitcoin is a fracturing of the network on the basis of anti–money laundering (AML) laws. Regulations of this sort are not only designed to hinder criminal behavior and prevent terrorist financing, but have been implemented by governments to maintain tax revenue. A network split may occur strictly along a clean-dirty dichotomy or, in all likelihood, through the categorization of white, gray, and black coins. Based on the latter hypothesized taxonomy, white, or clean, coins, would be those held in custodial accounts (e.g., Coinbase, Gemini, or Binance). These exchanges employ stringent know-your-customer (KYC) requirements for their users. Gray, or questionable, coins, would be identified as cryptoassets held in noncustodial wallets, where the owner has possession of their private keys. While these privately owned addresses don’t have any direct link to illegal activities, anyone who wanted to move their gray coins onto an exchange would likely be forced to answer invasive questions about their identity and the source of funds. Lastly, any coins used on the dark web or for purchases labeled nefarious would be branded black, or dirty, coins. Coins of this sort would be immediately frozen if deposited into a regulated exchange.

Signs of a splintered bitcoin network can be seen across the globe. In overadherence to Dutch legal requirements, crypto exchange Bitstamp now requires users to provide information on their net worth, nationality, proof of residence, and source of funds prior to withdrawing. Proposed guidelines issued by the Financial Action Task Force (FATF), an influential intergovernmental body, have labeled peer-to-peer transactions between unhosted wallets higher risk. FAFT goes on to recommend enhanced recordkeeping by virtual asset service providers (VASPs) to mitigate risks when interacting with unhosted wallets. On Reddit and Twitter, there are numerous firsthand accounts of exchange bans for using mixers, which are tools designed to preserve privacy. As evidenced by these examples, gray coins are already viewed suspiciously. On the pristine end of the taxonomy, industry executives have claimed that virgin bitcoins, those freshly mined, with no transaction history, sell at a 10 to 20 percent premium. As a whole, it’s clear that cryptoassets of the same denomination are treated differently and that a hierarchy of value has emerged based on a coin’s history.

Regulatory obligations have made the identity of the medium of exchange increasingly salient. An emphasis on coin history has naturally incentivized the formation of companies capable of identifying risks (e.g., Chainalysis or CipherTrace). In many cases, though, users are branded guilty by association, as these companies apply imperfect information in constructing risk profiles for privately owned crypto addresses. If this trend continues, the salability of nonfungible currencies will suffer. In tracing the origins of money, Menger (1892) states that the population selects the most marketable good to use as a medium of exchange. This creates a reinforcing cycle that increases the demand for this type of good. Reductions in the salability of bitcoin will ultimately negatively affect its desirability and its real-world uses.

Privacy is an attribute that people tend to disregard until it’s desperately needed. Institutions have thus far clamped down on financial crimes, but the phenomenon of cancel culture and the rabid silencing of dissident voices across social media is a dangerous precedent that sets the stage for the ubiquitous refusal of financial transactions based on political or social beliefs. When currency units contain a history, financial activity can unearth the ideological leanings of its possessor. Communities under totalitarian regimes in particular are at the greatest risk in this regard.

Markets are attempting to address the issue of fungibility, however. For example, cryptocurrencies such as Monero, Zcash, and Dash all claim to provide crypto users with added layers of privacy and fungibility. Crypto users themselves will determine in the long run which currencies—if any—provide a sufficient amount of privacy and fungibility. 

References

Berg, A. 2020. “The Identity, Fungibility, and Anonymity of Money.” Economic Papers 39, no. 2: 104–17.

Menger, Carl. 1892. “On the Origins of Money.” Economic Journal 2, no. 6: 239–55.

Mises, Ludwig von. 1953. The Theory of Money and Credit. New Haven, CT: Yale University Press.

Powered by WPeMatico

Mises Institute
The Mises Institute, founded in 1982, teaches the scholarship of Austrian economics, freedom, and peace. The liberal intellectual tradition of Ludwig von Mises (1881-1973) and Murray N. Rothbard (1926-1995) guides us. Accordingly, we seek a profound and radical shift in the intellectual climate: away from statism and toward a private property order.

Leave a Reply

Your email address will not be published. Required fields are marked *