Fungibility refers to the ability to seamlessly exchange one unit of currency for another without it being censored due to its history. Money in a bank account is not as fungible as cash, as banks can trace back funds to illicit activities but cash notes do not allow for such a provision. Fungibility is what keeps the value of the currency alive by maintaining trust in the currency’s use as a medium of exchange. Bitcoin’s lack of on-chain privacy is a direct attack on this proposition.
Money has no utility if the participants in the economy do not believe that it gives them the ability to freely use it to purchase the goods and services they desire. In fact, a form of money requires trust to function as a medium of exchange. Bitcoin eradicates the need to trust the system itself by providing evidence and verifiable proof that everything is in order and no entity controls the state of the network.
However, despite this eradication of trust in the system, people still need to trust Bitcoin as a value proposition. Fungibility introduces the ability to freely exchange the native currency without worrying that it has a tainted history that can be used against you despite you personally having no role in the illicit activity.
Bitcoin’s inherent transparency means anyone can track any source of funds and find out with UTXOs are linked to those of a particular hacker, scammer, or criminal. For example, Chainalysis tracks money launderers using Bitcoin and helps exchanges blacklist any addresses associated with these entities. But there are casualties that occur from this.
Take the example of Mr. X, a taxpaying citizen with a clean transcript and no criminal history. He’s an ardent Bitcoin supporter and consults for various businesses in the space. One fine day, a payment he receives is blacklisted by exchanges and flagged as “laundered money.” Eventually, he finds out the business that paid him indulged in nefarious activities such as money laundering. Now, every address he sends those funds to gets a label of being associated with money launderers. This trail continues forever and essentially leads to the funds being unusable.
If on-chain privacy algorithms were introduced, Bitcoin UTXOs couldn’t be so easily tracked and linked from one to another. Yes, this is a major impediment to those who are truly trying to crack down fraud, and this emboldens those who indulge in such activities. But it saves Bitcoin as an economic system since everyone now knows BTC cannot be tainted by its history.
Lack of fungibility is evidenced by Chinese investors paying a premium for BTC straight from Coinbase to a miner wallet. This premium was a blatant attack on fungibility and highlighted the need to enable on-chain privacy measures.
Without fungibility, Bitcoin cannot thrive and empower individuals. With each passing day, the need for on-chain privacy is becoming dire. Hopefully, 2020 is the year this finally happens.