Is fungibility Bitcoin’s Achilles heel?
The wakeup call
Lately, three things brought Bitcoin fungibility back into my face.
First, an interview of Kevin O’Leary on Stansberry Research youtube channel where he explained he got a deal with some miners to get pristine coins for his clients. He goes as far as comparing some bitcoin to blood diamonds in case they would be mined in certain countries.
The second one, is the latest play between Elon Musk and Michael Saylor to create a so called “miners council”. If you add some regulation on top of that, it could quickly create a situation where some coins are deemed greener than others depending on their source.
Lastly, some exchanges like crypto.com have started implementing “travel rules” compliance to fulfill with certain jurisdictions regulations. This implies they will trace the origin of the crypto they receive although it is unclear how far they will go.
All of these show that market actors are attempting to quantify properties or value of coins against some external factors.
Bitcoin fungibility
Let us look at Wikipedia definition:
An asset is said fungible when individual units are essentially interchangeable, and each of its parts is indistinguishable from another part.
The implication is that two units of the same asset class hold the same exact value as they are indistinguishable.
A one dollar bill is the same as another one dollar bill. No matter who owns it, who earned or who transacted with it, they are deemed identical by law .
Is Bitcoin fungible ? Yes and no.
From an intrinsic point of view, there is no difference between one bitcoin and another, they both represent the same digital asset and are interchangeable.
However, there are aspects related to the public blockchain that facilitate the identification of the coin source and transaction history via the spent addresses.
One could in theory and with sufficient resources trace back all transactions and addresses a Bitcoin went through up to its genesis block and miner.
Merge those data with some KYC database and this would quickly get useful for anyone willing to trace coins.
As more countries adopt crypto mining regulations and specific travel rules, the partial fungibility of Bitcoin will become a way to assign different qualities and values to coins depending on their history.
In other words some Bitcoin will be better than others.
You might argue that it is very improbable anyone would commit resources for such a task. Well…
- It is entirely possible that for tax purposes, some governments will implement wallet address registration as an off-shore account.
- Let alone having a blacklist of addressees from tax evaders, apprehended criminals, etc…
- If a crypto business like an exchange requires a license to operate in certain jurisdictions then the regulator could enforce this.
- Same playbook for institutional investors that could loose their license.
- Due diligence required by the regulator would unlikely mean going back to the genesis block. Most likely tracing back the last 10~20 spent transactions history vs blacklisted addresses which is very feasible.
Possible scenario
- Institutional investors:
I can foresee this group willing to pay more for a Bitcoin that is guaranteed to be “green” and from a regulated source.
After all, it is very unlikely that a US pension fund would want to play the Russian roulette with their license by potentially taking Bitcoin from sanctioned countries like Iran or North Korea.
This would lead to some kind of Bitcoin tiers with some price premium:
- Tier 1: Green energy + from FATCA/AML/KYC compliant countries
Trading 30% premium above market price. - Tier 2: Non green energy + from FATCA/AML/KYC compliant countries
Trading 10~20% premium above market price. - Tier 3: Others (unknown, sanctioned countries, etc…)
Not suitable for institutional investors.
This is very likely to happen and quite feasible to some degree if we end up with a “guild” of green and regulation compliant miners a.k.a Michael Saylor’s miners council.
- Retail investors:
Considering there is no way for them to know their asset history, we would probably see the exchanges, fiat off-ramp solutions and possibly banks checking the coins short term history (10 to 20 last transactions) to comply with some sort of travel rules and/or capital control.
Of course, one could “wash” his coins by doing the right number of transactions between his own wallets so that the history looks clean.
But it has implications:
- First it is not necessarily accessible to the regular Joe and Jane from technical stand point
- It is a significant hassle with a risk of error (transfer to the wrong address) that increases with the history length required to be cleaned out.
- Each transaction has a cost.
- You could see banks doing risk control and limit crypto off ramp to a certain fiat amount (See the war on cash deposit in certain European countries)
- Finally, there is still the risk of the zealous platform that end up rejecting your coin because they checked more transactions than required and found it was from a black listed address. Then what’s the price of your coin on the black market ?
- It would also cripple the system since bad money drives out good money.
Imagine a system where most of the circulating coins are bad, the exchange would delay or even cancel most of the transactions due to non compliance to travel rules/AML.
In my opinion, neither the retail or the platform will want to go through that hurdle (Cost, risk, technical difficulty) in their great majority especially if this end up crippling the system.
Where does it leave us ?
I foresee the Bitcoin and other major crypto market becoming something similar to the commodity market.
- Institutional investors will have their market trading the real thing for premium like they would do for pretty much any commodity. There will be regulated miners, suppliers and custodians.
- The retail market will become an almost entirely paper market where people do not own the real thing and where there is 100 paper Bitcoin for a real one.
Is it that bad ?
Well, it goes against the whole idea behind Bitcoin of a decentralized and egalitarian asset or money for the people that is not controlled or manipulated.
To me this is a much larger threat to Bitcoin that an hypothetical quantum computer or mythical 51% attack.
Once it relies on a dual market of “good for delivery” and paper market then Bitcoin is not any better than other asset as it loses some unique qualities:
- Third party risk will exist.
- Not decentralized since you have “good” and “bad” market actors.
It would inevitably make the “good” regulated minors bigger and bigger as the demand/supply would drive that. - Virtually infinite supply via non allocated paper IOU in the retail market.
- Market can then be moved/capped via the paper market.
- Only the wealthy will be able to get their hands on the real thing.
The way out
Considering the problem is from fungibility then there are very few options:
- Taproot will be a progress but it is largely insufficient.
- Implement MimbleWimble on Bitcoin once it is working in Litecoin.
- Fork into a Monero or Zcash like blockchain. Is that even possible ?
But then what happens with institutional investors ? Complete fungibility would likely drive the big money out and destroy the market because they would not be able to comply with the regulations.
In other words it is maybe already too late unless true believers are ready to hold for a long long market glaciation and low price.
In the end we might see another asset with similar properties but better fungibility take over as a viable decentralized money for the people and by the people.
Disclaimer:
I’m not a certified financial advisor nor a certified financial analyst nor an economist nor a CPA nor an accountant nor a lawyer. I’m not a finance professional through formal education.
The information provided in this article are only my personal opinions and experiences. They are purely for educational purposes and they should not be considered a financial advice. Do your own research.
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