Tainted money

In many parts of the world, cash held in ATMs or in cash-in-transit vehicles is protected by so-called intelligent banknote neutralization technology. When a thief tries to force the ATM open, plastic packs filled with dye explode, spraying both the thief and the banknotes. These notes have now been demarcated as stolen. A shopkeeper may refuse to accept marked notes or may only accept them at a large discount to their face value. At this point, cash has ceased to be fungible. One banknote is not a perfect substitute for another.

The dye used in banknote neutralization is often mixed with a taggant, a chemical marker that contains a unique combination of elements chosen from thirty or so rare earth metals. This ensures that a given block of cash is protected by a one-of-its-kind dye pack. So if the authorities apprehend the ink-stained thief with the marked cash, they can actually trace the stuff back to its original owner and return it. This incentivizes any would-be ATM thief to think twice.

Cash is normally fungible. Norway has an interesting way of keeping crooks from robbing ATMs. Exploding dye packs in the ATM stain the stolen notes. Now that they are no longer fungible, the notes are far less marketable. https://t.co/r29NOZXasI pic.twitter.com/0IRGbskur0

— JP Koning (@jp_koning) July 16, 2018

An analogy can be drawn to bitcoin. Each bitcoin's history is indelibly recorded on the bitcoin blockchain. So if a coin is reported stolen, it is theoretically possible for law authorities to see the movement of the stolen coin as it passes from owner to owner. Any buyer of bitcoins needs to be concerned with the possibility that they will be confronted by the authorities and obliged to return that coin to its original owner. This possibility could affect the fungibility of bitcoins. Coins with clean histories may trade at a premium to those without clean histories.

This similarity between tainted bitcoins and banknotes is only superficial, however. In most parts of the world accepting stolen bitcoins is far more risky than accepting stolen banknotes. Even if a seller does their best to make sure that a buyer's bitcoins aren't stolen, they could be legally obliged to return the bitcoins to their rightful owner if their analysis is wrong. The legal treatment of stolen banknotes is different. A seller can mistakenly accept stolen banknotes but as long as they have done so in good faith, they cannot be legally obliged to return them to their original owner.

Good faith means honestly. If a seller knows that the buyer is using stolen banknotes, then the seller would not be acting in good faith if they accepted those notes. If the seller has no knowledge about whether the notes have been stolen, then they are acting in good faith if they accept them. This state of mind is sometimes referred to as acting with a pure heart and an empty head.

The difference between bitcoins and banknotes is best illustrated by an example. Say I am holding a garage sale. A thief buys a knickknack from me using a stained $10 note. I am not familiar with intelligent banknote neutralization, so I do not know that the banknote has been stolen. I try to deposit the stained note at the bank and the bank notifies the police. Thanks to the taggant, it can be proven that the note was stolen from Bank X's ATM a few days before. Since I innocently accepted the note i.e. I did so in good faith, I am not obligated to give it up to Bank X. If, on the other hand, I knew about intelligent banknote neutralization, and this could be proven in court, then I would be obliged to give the note back. But it was an honest mistake, and so I am forgiven.

Continuing the example, say the thief bought another knickknack at my garage sale using bitcoins. Prior to accepting his bitcoins, I did a careful analysis of the blockchain to see if the coins had been stolen, but nothing turned up. It turns out my analysis was flawed. In actuality, the thief held-up a bitcoiner at gun point the night before and stole her bitcoins. Even though I did my very best to ensure they weren't stolen, I could be obliged by the law to give the bitcoins back to their original owner.   

The law is very forgiving towards users of banknotes. Sellers can be fairly uninformed, or objectively stupid if you will. They can make honest mistakes accepting banknotes. But an honest mistake with bitcoin could be very costly. With bitcoin, there is no protection for fools.

In the above example, bitcoins are treated by the law as regular property. When someone steals a piece of property, say a painting or a car or a piece of jewelry, and sells it, the law needs to determine which of two innocent parties gets to keep the property; the owner who was robbed or the buyer who innocently gave up something to the thief in return for the stolen property. For almost all types of property, including paintings and cars and jewelry (and bitcoin), the law usually favours the original property owner. Even though the new owner participated in the transaction in good faith, they must return the stolen goods. 

Banknotes have been granted special status by the law. They are one of the few types of stolen property that an innocent third party gets to keep. As a result of this exception, trade conducted with banknotes is far more fluid than trade conducted with other types of property. A seller who is offered a banknote doesn't have to worry about investigating that note's past history to verify that it was stolen. This greases the wheels of commerce. But it comes at a price. The property rights of the original owner have been thrown under the bus.

Should the exemption that has been granted to banknotes be extended to bitcoin? Probably not. Property rights are very important. If we trample on them at all, it should only be in certain situations where there is a very good reason for doing so. At the time that English courts originally granted the property exemption to banknotes they were already responsible for a large portion of England's commerce. This is still the case, with cash generally participating in for around half of the UK's retail payments.

Treat banknotes as regular property and people would have to take on the full risk of accepting stolen notes. This would put a significant damper on trade. Bitcoins are not used for buying and selling things at a retail level. When bitcoins pass from one hand to the other, it is almost always for speculative reasons, not mercantile ones. Given that the bar for removing the property rights of the original owner should be a high one, bitcoin probably doesn't clear the hurdle.