A few centuries ago, lack of fungibility used to be a big weakness of monetary systems. But technological and legal developments eventually solved the problem. Nascent systems like bitcoin are finding that they must wrestle all over again with fungibility issues.
Fungibility exists when one member of a population of items is perfectly interchangeable with another. So for instance, because your grain of wheat can be swapped out with my grain without causing any sort of change to our relative status, we would say that wheat grains are fungible. Fungibility is a desirable property of a monetary system. If all monetary items are interchangeable, then trade can proceed relatively smoothly. If monetary items are not fungible, then sellers cannot accept the monetary item without pausing for a few moments to verify and assay it, and this imposes frictions on trade.
In this post I argue that there are two ways for something to be fungible. They can be fungible for physical reasons or for legal reasons.
By physical fungibility, I mean that members of a group are objectively indistinguishable from each other. In the previous example, our wheat grains are physically fungible because a cursory inspection shows that they look, feel, and smell exactly the same. Now, a deeper analysis might reveal that the two grains are not in fact perfectly fungible. For instance, it may be the case that your grain of wheat is the hard red winter variety and mine is durum, in which case they are not substitutes, durum being better for making pasta. Or perhaps we each have durum grains, but yours enjoyed an excellent growing season—plenty of sun and sufficient rain—whereas mine isn't so healthy. And so your grains can produce more pasta per than mine. And thus they aren't exact substitutes.
We could even go down to the molecular level and determine that the grains are not perfectly equal and thus not quite interchangeable. But for commercial purposes, there is typically some sufficiently-deep level of analysis at which fungibility between types of wheat grains can be established by an experienced grain inspector and accepted by the market.
Among commodities, gold and silver achieve a notably high level of physical fungibility. As long as a gram of gold is pure, it is perfectly exchangeable with any other gram of pure gold. Gold's fungibility doesn't necessarily carry over to gold coins, however. Earlier processes used to make coins, in particular hand striking, were not very effective at creating perfectly equal specimens. The edges of coins were often irregular, leaving coins vulnerable to clippers who would safely cut off some gold (or silver) without fear of being detected. Thanks to natural wear and tear, coins that had been in circulation for a few years would contain less precious metals than new coins. Both clipping and natural wear & tear meant that the metal content of coins was not uniform.
New technologies helped increase the physical fungibility of coins. For instance, reeded edges—those little lines on the edge of a coin—prevented people from clipping off bits without detection. It was now obvious to the eye if someone had attacked the coin. Likewise, shifting from hand-hammered coinage to mechanical screw presses allowed for a more circular final product, one less susceptible to clippers (see comparison below). The invention of restraining collars—which prevented metal disks from shifting around while they were being stamped—also helped. With clipping much reduced, coins that had been in circulation for a while were more likely to be equal in weight to new ones.
These two photos compare hammered coins to milled ones (source)
In addition to physical improvements, an attempt was also made to buttress the fungibility of coins with laws. There are two types of laws that achieve this: legal tender and the so-called "currency rule." Legal tender laws required debtors and creditors to accept all coins deemed legal tender by the authorities at their stipulated face value. So even if two different shillings were not physically fungible--say one was clipped and worn and thus contained far less silver than the second newer one--those participating in trade were obligated to treat them as if they were perfectly interchangeable.
Legally-enforced fungibility was no panacea. In the absence of physical fungibility, the imposition of legal tender laws often had perverse effects. If two coins were not exact physical substitutes because their metal content differed, but law required them to be treated as interchangeable tender, then the owner would always spend away the lighter one while hoarding the heavier one. Legal tender laws, after all, had artificially granted the "bad" coin the same purchasing power as the "good" coin. Thus the good money is chased out by the bad, which is known as Gresham's law.
The second set of rules that courts formulated in order to help fungibility, the currency rule, requires us to shift our attention to banknotes. Like coins, banknotes are not particularly fungible in the physical sense, but for a different reason. Banknotes have historically carried a unique identifier, a serial number—coins haven't. An owner of a banknote can carefully jot down the serial number of each note and, if it is stolen, use that number to help track it down.
In 1748, Hew Crawfurd did exactly this. Before sending two Bank of Scotland £20 notes by the mail, Crawfurd not only recorded their numbers but also signed the back of each one with his name, thus further breaking down their physical fungibility. When they went missing, Crawfurd was able to use this lack of fungibility to his advantage by advertising in the newspapers the numbers of the two stolen notes and the fact that they had been signed by him. One of the notes was eventually identified after it had been deposited at a competing bank, presumably long after the robber had spent it. The bank, however, refused to return the stolen property to Crawfurd.
In the resulting court case, the judge ruled in favor of the bank. Crawfurd would not have his stolen property returned to him. The court reasoned that if the note was returned to Crawfurd, then no merchant would ever risk accepting a banknote unless they knew its full history. This would damage the "currency" of money. After all, requiring merchants to pour through newspaper after newspaper to verify that no one was advertising a particular serial number as lost or stolen would be prohibitively expensive. Banknotes would be rendered useless, depriving the Scottish economy of much of its circulating medium. By allowing merchants to ignore the lack of physical fungibility of banknotes, i.e. the unique marks on each banknote, the court recreated fungibility by legal means. To this day, the currency rule that was first established in Scottish courts in the 18th century continues to apply to banknotes in most legal systems. (Kenneth's Reid's full account of this case is available here).
Bitcoin, a purported monetary system, is interesting because it: 1) lacks physically fungible and 2) is unlikely to ever be granted legally fungibility in the form of legal tender status or via an extension of the currency rule.
Bitcoin's lack of physical fungibility is more similar to that of banknotes than coins. It arises from the fact that all bitcoin transactions are publicly recorded. This means that it is possible to trace the history of a given bitcoin. If the token has been stolen, say in a highly-visible exchange hack, then said token may not be as valuable as a bitcoin that has a clean history. In theory, a forward-thinking actor will only accept a tainted coin at a discount because there is always a risk that the original owner will be able to reclaim his or her stolen property.
There seems little likelihood that the courts will solve bitcoin's lack of physical fungibility by fashioning a form of legal fungibility for it. The state will probably never be friendly enough toward bitcoin to grant it legal tender status. Nor do I think it is advisable that courts extend the currency rule to bitcoin by granting merchants the right to ignore the trail left by a given bitcoin, as they do with banknotes. As I pointed out here, to do so would violates the property rights of the original owner of the stolen objects. Only a select few instruments, those that have already proven themselves to be vital to facilitating society's trade, should be protected in this way.
With no legal route to establish fungibility, the only path remaining for bitcoin's architects is to go back to square one and try to improve the physical equivalency between bitcoins. One way they can do so is by anonymizing the blockchain. If transactions can no longer be traced, than clean and dirty bitcoins all look exactly the same. Full anonymity is easy to implement in new cryptocurrencies. Monero and Zcash, for instance, have gone this route.
In the case of a legacy cryptocurrencies like bitcoin, this functionality would have to be added on to its existing codebase. I have heard rumours that bitcoin developers like Adam Back and Greg Maxwell are working on developing code for anonymizing the bitcoin blockchain. But even if the technology is up to snuff, given the difficulties of achieving sufficient consensus for upgrading bitcoin, it remains to be seen if a fungibility-restoring technology could ever get off the ground.
In my view, the idea that bitcoin developers must try to achieve the same level of fungibility as coins and banknotes is misguided. Proponents of this idea are operating on the assumption that bitcoin is, like coins and banknotes, a payments medium or monetary system. But this is wrong. Whatever its original purpose might have been, bitcoin's first and foremost role is as a new type of gambling machine, a global and decentralized financial game. Like lotteries, casinos, and poker tournaments, and other types of zero-sum games, the main service that bitcoin provides its users is the fun of gambling and the allure of becoming very rich. If they want to benefit their users, Bitcoin developers should be working towards furthering its role as a gambling machine rather than mistakenly pursuing the dream of becoming the next monetary system.
People who play financial games such as lotteries benefit from the unique serial number on lottery tickets. If their tickets are stolen from them, this identifier may allow the original owner to get their ticket back. And that way they can still potentially win the big pot.
The same applies to bitcoin. Most people who hold bitcoins are doing so because they expect its price to hit $1 million. At least if their coins can be traced, a bitcoin owner who has been robbed may still have a chance to win that jackpot (and buy that Lamborghini they've been dreaming about). Removing the very feature that makes bitcoin non-fungible—and thus potentially traceable in the case of theft—would only do harm to the average bitcoin user. Anonymizing the bitcoin blockchain would make about as much sense as removing the serial numbers on lottery tickets.
Bitcoin's lack of fungibility isn't a bug, it's a nice feature.