What is the essence of bitcoin fungibility and why is it so important?
Fungibility refers to the concept that every unit or subunit remains equivalent and identical to any other unit or subunit. It is the property of a good or commodity whose individual units are capable of mutual substitution.
For instance, one bitcoin is considered the same as any other bitcoin when it comes to price and acceptance. Gold bullion has fungibility with identical degrees of fineness or purity. Government paper cash has fungibility provided that the bills have not been marked or serial numbers have not been 'blacklisted.' In other words, you cannot be held responsible for the historical path of that banknote prior to its acceptance by you.
Herein lies the controversy. Should you care where your money came from and how does a monetary system cope with the resultant risk placed upon the bearer?
Recently, it has become fashionable in some bitcoin circles to suggest that blacklisting, or the more palatable term of redlisting, can be implemented to discourage the large-scale stealing of bitcoin wallets or even the ransom demands of petty criminals like CryptoLocker. Either way, it boils down to some form of coin validation with the more insidious side effect being government collusion with the coin validators for purposes of linking individuals to all of their transactions.
A related Scottish monetary case from the 1700s suggests that coin validation is a misguided premise. Fortunately, the judges in that case upheld the principle of unrestricted fungibility. Altering the monetary framework through blacklisting, redlisting, whitelisting, or any variant of subjective taint measuring would have catastrophic implications for the integrity of the financial system, thus detrimentally impacting economic prosperity for the whole.
Although opt-in efforts at sanitizing bitcoin or ensuring proper clean coins will inevitably emerge in a free market, that does not mean they are necessarily beneficial for the larger bitcoin economy and the principles of a non-politicized monetary unit.
Fortunately, the political and market-based efforts to disrupt the integrity of a digital currency will be met with high-powered technical solutions, effectively rendering coin validation techniques useless in a sea of powerful circumvention.
"To stop this nonsense we have to make it impractical to pull off by changing the default behavior in the bitcoin ecosystem. We consider the lack of a central authority to be an essential virtue, which means that we can't be protected by one either. We must protect ourselves. This means things like avoiding address reuse, avoiding centralized infrastructure, adopting-- and funding!-- privacy enhancing technology."
Distributing mining and Hashcash creator, Adam Back, was simply astonished, exclaiming: "Their technical representatives of Coin Validation should be ashamed. How can someone who doesn't understand a concept as basic as fungibility and its relation to transaction costs, and the difference between identity and coins hope to exist in this ecosystem."
Harming bitcoin growth
Private sector attempts at promoting coin validation to seek favor with regulators are doomed to failure, because Bitcoin operates as a worldwide network with a border-less monetary unit. At the jurisdictional level, economies that embrace coin validation knowingly erect barriers to the free flow of digital capital and restrict the beneficial properties of bitcoin-induced growth in that particular region. It would be similar to "blacklisting" that entire jurisdiction from the world economy.
With the Unites States at an embarrassing 2% of all worldwide exchange volume for bitcoin trading, I cannot imagine that government authorities would want to take any steps which make the jurisdiction even less appealing.
Quite the opposite would be the economically sound position for US regulators to take.
If Director J. Shasky Calvery at FinCEN were sincere about attracting bitcoin-related companies to the US and not inhibiting innovation, she would have FinCEN make a public pronouncement that banks in compliance with existing AML laws and KYC guidelines have nothing to fear from engaging in business with bitcoin companies.
Additionally, FinCEN should state explicitly that it rejects coin validation and any other attacks on unrestricted fungibility for bitcoin, because this would undoubtedly taint the jurisdiction.
This type of leadership action would accomplish two objectives. First, it would serve to establish the longer-term principle that bitcoin trading does not require regulation as a government-issued financial instrument (as other jurisdictions have done).
Secondly, it would lift the cloud of the chilling effect emanating from one of the country's leading law enforcement agencies, which we all know is an obtuse method to control and gain preemptive compliance in an extrajudicial manner.
At the economic level for bitcoin businesses, any exchange or merchant that attempted to launch or participate in a coin validation scheme would find themselves largely shunned by the user community. Given such massive disapproval from the bitcoin user community, organized boycotts against certain companies could become a reality.
Conversely, any exchange or merchant that rejected coin validation schemes or redlisting would experience a dramatic increase in business volume. This fact alone should produce a stabilizing effect due to the incentives aligned against the validation trolls.
Protecting the core Bitcoin protocol, including unrestricted fungibility as it relates to bitcoin transactions, mining, and acceptance, requires vigorous defense of bitcoin transactions that are free from third-party validation because such validation jeopardizes overall fungibility and creates transactional friction.
Proactively, I call upon the Bitcoin user community and Bitcoin infrastructure companies to oppose any initiatives that attempt to undermine bitcoin fungibility and to support solutions that promote the broad adoption of privacy enhancing technologies for bitcoin.
However, do not worry, for bitcoin fungibility is inherently protected by design. If all else fails, there is always the ultimate solution to "fork off" the debilitating, validation-seeking Govcoin chain and become free again.
Disclaimer: The views expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to, CoinDesk.
Follow author on Twitter.