A Look at Bitcoin Fungibility and Why It’s So Important

Data & Research / 31.03.2021

Bitcoin fungibility has long been the center of a debate that has waged on since its early days. In Bitcoin’s infantile stage, most people wrongly believed the coin to be anonymous. However, nowadays, it’s well-known that Bitcoin isn’t private. In most ways, due to its open blockchain, it’s quite the opposite. This realization has led to some heated debates regarding the world’s fungibility’s first cryptocurrency.

What is fungibility

To understand the Bitcoin Fungibility debate, you first need to understand what fungibility is and why it’s vital for a monetary system. Fungibility is a term that refers to the ability of a currency to be exchanged for another of the same currency without any change in value. Notably, fungibility plays a vital role in the way blockchains work.

For example, gold is fungible, meaning any two pieces of gold that are of the same grade and weight hold the same value. They are indistinguishable from each other. Fiat currency is semi-fungible for a few reasons. Yes, any two-dollar bills hold the same value in theory. However, there are unique serial numbers on each bill that can track and record a certain bill’s history. In the past, these serial numbers have been used to track fiat currency globally.

Fungible vs. Non-Fungible Tokens

Nun-fungible tokens (NFTs) are different than fungible tokens in that they are unique in nature. They are not interchangeable for other tokens of the same technical characteristics. Each NFT holds its own value based on what it represents. Some NFTs represent real estate, documents, art, and more.

Is Bitcoin Fungible?

The answer to this question is yes and no. Bitcoin is considered semi-fungible because, in its natural state, it’s not as anonymous as gold or fiat currency. All Bitcoin transactions are traceable. Since it can track it, it leaves regulators in a position of power to ban or blacklist certain coins in the future.

Whenever an asset or currency is monitored and tracked, it becomes less fungible. This loss of fungibility causes problems when third-parties attempt to freeze accounts or refuse to accept coins that received or sent payments from blacklisted wallet addresses. As of yet, this hasn’t occurred on a large scale, but it is a real concern that has developers discussing ways to protect what’s left of the coin’s fungibility.

Traceability vs. Fungibility vs. Liquidity

Traceability and fungibility are not the same things. Trackability is how easily one can discover the history of an asset. As such, it’s just a small fraction of what makes a currency fungible. Additionally, liquidity and fungibility are not the same things. Liquidity is how easily you can convert an asset into liquid assets.

What Problems Does Bitcoin Fungibility Attempt to Fix?

One of the main reasons why Bitcoin needs to remain semi-fungible is to prevent censorship. Imagine that you went to cash out your Bitcoin, and governments or regulators stepped in to tell you that you couldn’t because you had used the coin to commit a crime years earlier. This scenario could one day become a reality if Bitcoin’s fungibility isn’t protected at all costs.

There have already been cases of exchanges attempting to block or eliminate certain Bitcoin based on its origins. The more common the blocking of Bitcoin transactions becomes, the less fungible the coin. Eventually, there may become a scenario where there are two types of distinct Bitcoin, clean coins and blacklisted ones. If this occurs, Bitcoin will see turbulent price swings, leaving many people with Bitcoin worth less than its counterparts.

Varying Prices of Bitcoin

Fungibility is critical to ensure that all Bitcoin retain the same value. Tainted Bitcoins, much like tainted gold, or fiat currency, must remain part of the circulating supply. This strategy is necessary to ensure the total monetary system remains intact.

Benefits of Bitcoin Fungibility

It would help if you had Bitcoin to remain fungible to operate an open and decentralized market. The less trackable
Bitcoin becomes, the more it remains free from manipulation by outside parties or organizations. Of course, for Bitcoin to retain its semi-fungibility, it must regain some of its anonymity.

Bitcoin Fungibility Legal

There are a lot of legal arguments brought up when debating Bitcoin’s fungibility. People often confused Bitcoin fungibility with anonymity. They are not the same thing. However, anonymity does play a role in the overall fungibility of the coin. In its current state, Bitcoin is fully traceable. Anyone can pay a blockchain forensic firm to discover the history of an account, and in most cases, the identity of the owner of the account.

Hard Forks

The legal arguments against Bitcoin fungibility begin to get murky when you start to venture deeper down the rabbit hole. For example, hard forks. Technically speaking, direct hard forks, like Bitcoin Cash, share the same serial numbers and UTXOS as their Bitcoin origins. Despite these technical similarities, hard forks don’t hold the same value as Bitcoin. For example, you can’t get a Bitcoin loan and repay the same amount of coins in Bitcoin Cash.

Protecting Bitcoin’s Fungibility

A growing number of developers have sought out to protect Bitcoin’s fragile fungibility. Since its first days, Bitcoiners have dreamed of truly anonymous transactions. Interestingly, there are even coin anonymizing protocols such as CoinJoin built directly into the Bitcoin Core interface. Here are some other popular projects that could help protect Bitcoin’s fungibility in the future.

Lightning Network

The Lightning Network is an off-chain protocol that enables users to send and receive unlimited payments via private payment channels. When the channels are closed, the payments then post to the blockchain. As a second layer protocol, the Lightning Network has far more flexibility in obfuscating your payment history. Consequently, Lightning Network developers have been working on a variety of different private transaction options.

Coin Mixers

Coin mixers can help you to keep the origins of your Bitcoin secret. There are a variety of different platforms that provide this service. In most instances, the platform will mix your coins with other transactions and addresses. While this approach is very effective, it’s not 100% full proof, and some high-end forensic firms had discovered ways to locate when a mixer was employed.

Some wallets offer this feature directly. The Wasabi Wallet takes the concept of coin mixing and expands on it. The network automatically mixes all wallet holders’ coins. This approach simplifies the entire process and helps to keep Bitcoin fungible and your identity private.

Is Bitcoin’s Future Fungible?

Now that you understand why it’s paramount that Bitcoin, at the very least, remains semi-fungible, you’re ready to do your part. Remember, coin mixers aren’t a full-proof way to obfuscate your Bitcoin, but they help make it more expensive to track your transaction history. In the coming months, you can expect developers to deliver a truly private Bitcoin transaction to the world. For now, the Bitcoin fungibility debate will continue.

David Hamilton aka DavidtheWriter is a long time Bitcoinist and cryptocurrency journalist. Currently, he has over a thousand articles published on blockchain technology. His expertise and experience makes him one of the most reputable writers in the sector.