Michael J. Casey is the chairman of ExposedCrypto’s advisory board and a senior advisor for blockchain research at MIT’s Digital Currency Initiative.
The following article originally appeared in ExposedCrypto Weekly, a custom-curated newsletter delivered every Sunday exclusively to our subscribers.
Imagine if flour millers insisted on knowing the precise identity and originating farm of each grain of wheat delivered to them.
It would render the global wholesale crop market dysfunctional. That market depends on buyers accepting products from warehouses and shippers even though they don’t know their origins.
At the heart of this system is the ancient principle of fungibility: the idea that one unit of a particular product is perfectly interchangeable with another.
This principle depends upon an unspoken agreement between market participants that information about a product’s history is not only hidden but is actually lost. A product having this quality is, more or less, the very definition of a commodity.
Fungibility is even more important to money. Our system of money requires that each dollar be completely interchangeable with any other dollar. For it to function perfectly, users can have no knowledge of the history of each of those dollars.
I like to define money as a communication system that uses a commodity (the currency) to convey information about transfers of value. If the commodity’s fungibility is challenged, the power to communicate that information is diminished.
You could say that assuring the fungibility of a currency is a matter of free speech. Just as importantly, the breach of freedom means that the system of exchange itself breaks down.
It’s all about privacy
It boils down to privacy. Without the history of transactions being obscured, money doesn’t function so well.
If we knew where every distinct unit of currency had been, it would assume the quality of a distinct, identifiable form of property. And that would leave our money subject to liens and asset seizures by creditors or law enforcement agents taking actions against other people.
This is critical to the argument around privacy in the blockchain and cryptocurrency communities.
Unless you’re listening to the outdated, false talking points of some anti-crypto crusaders, you’ll know by now that bitcoin, which keeps a record of every single input and output, is not very private. (If you’re going to do a giant drug or arms deal that you want kept out of view, it’s much better to use a briefcase full of Ben Franklins, not bitcoin.)
This aspect of bitcoin raises serious questions about its fungibility.
The same questions will arise around the myriad new blockchain platforms for exchanging digital assets. For these systems’ crypto-economic incentive and governance models to fulfill a promise to resolve trust problems and enhance community coordination, their tokens must be fungible. (Note: this interchangeability is required even when the token represents a claim on a piece of distinct, underlying property, such as a share in a piece of real estate.) And that means that they too must address the privacy dilemma.
Even as the understanding of bitcoin’s privacy limitations improves, and as mathematicians such as Blockstream’s Andrew Poelstra seek to overcome them, the public debate over this matter still mostly misses the bigger point of fungibility.
As cryptographic tools for enhancing privacy have been incorporated into cryptocurrency projects, including zero-knowledge proofs (zcash), ring signatures (monero) and bitcoin mixers, the debate over their value to society is too narrowly viewed as a battle between privacy as a human right on the one hand and society’s need to prevent criminality on the other.
But serious cryptographers working on these tools make a bigger and more important claim: privacy is needed to enhance the “moneyness” of cryptocurrency.
It is a vitally important task, because, as it is, our entire global system of money has also seen its fungibility deteriorate, precisely because privacy has been eroded.
Even though, for the most part, a dollar is still treated as interchangeable with any other dollar, increasingly stringent anti-money laundering rules are undermining that system.
The cost of compliance
It began well-intended, with the U.S. Bank Secrecy Act of 1970, which requires banks to identify customers before permitting them to use their services and to, effectively, monitor their behavior.
The BSA became a powerful weapon in the U.S. in the War on Drugs, and its principles became ever-more ingrained into our financial system. There’s now an elaborate global system of outsourced monitoring aimed at using money trails to catch bad guys.
It’s debatable how successful these programs have been. The United Nations Office on Drugs and Crime estimates that up to $2 trillion is laundered annually, or 5 percent of world GDP. Governments’ answer to that problem has, predictably, been to add even more surveillance and compliance requirements.
What is clear is that all these rules end up curtailing the flow of money around the world, especially that of honest actors.
Since the 2008 financial crisis, and following some heavy fines against banks that serviced drug cartels or dealt with sanctioned entities on the Office of Foreign Assets Control (OFAC) list, “know-their-customer” (KYC) identification requirements have become a major cost drain for most banks.
These compliance costs are now so burdensome that many have been pulling back from perfectly reasonable businesses that their compliance officers deem “risky.” Entire regions such as the Caribbean have suffered debt crises because of this “de-risking” problem.
Banks might still function somewhat like those grain warehouses, bundling deposits in a way that doesn’t distinguish one dollar from another. But I would argue that this excessive compliance process has, in effect, made the global monetary system less fungible. A dollar transmitted by an “unbanked” individual in the Bahamas is now worth less than a dollar wired by a fully “KYC-ed” U.S. bank client.
Bitcoin promised a way around this problem. There was no need to personally identify oneself to gain access to bitcoin currency; you merely had to download the software and generate a public key that contained no identifying information. Many of us saw it as a solution for the unbanked of the developing world.
But since bitcoin wasn’t widely used by the general public, users inevitably had to interchange coins with fiat currency, which meant interfacing with the banking system. Once bitcoin wallets and exchanges were subject to KYC rules, they created identifiable on- and off-ramps, which, when combined with bitcoin’s permanent, immutable, blockchain ledger, created a clearly traceable record of every bitcoin transaction.
This is how the U.S. Department of Justice caught those rogue Secret Service agents who thought they could abscond with bitcoins seized in their investigation of Ross Ullbricht, the convicted founder of the Silk Road marketplace.
We’ve already seen how bitcoin’s traceable history undermines fungibility. When the FBI launched a series of auctions of bitcoins seized in that same investigation, it attracted giant bids that put a higher price on bitcoin than that quoted on exchanges.
Why? Because these were “whitewashed” coins; no FBI agent would seize these again. It turns out that one bitcoin can be more valuable than another.
Imperfect fungibility means that people will tend toward holding bitcoin as a speculative asset rather than using it as a medium of exchange. Speculation is all well and good, but if bitcoin can’t be used for purchases, it’s an impractical form of money.
Privacy = freedom = a healthy economy
Yet because governments are unwittingly creating the same problem with their own money, cryptographers working on privacy solutions for cryptocurrencies have an opportunity to enhance economic activity, not only in the world of crypto, but the world over. In doing so, they’re also striking a blow for freedom.
That’s because privacy is not only critical for monetary fungibility, it is the foundation of freedom. In the years ahead, as economic activity becomes increasingly digital, I believe this duality of privacy and freedom, measured by how easily our value exchange systems allow us to transact with each other, will become the defining differentiator between economic systems.
Consider China. The rapid expansion of digital payments there, led by Alibaba’s Alipay and Tencent’s WePay, has caught the world’s attention. It’s driving other governments to vow to create “cashless societies.”
But as the Chinese government expands its surveillance state, replete with its ominous “social credit score” measuring and incentivizing citizens’ behavior, the traceability of those digital payments looks quite worrying.
At what point does a digital transaction model’s threat to privacy, fungibility and economic activity outweigh its ease-of-use advantages? This, I believe, could be the defining issue in a global competition between open versus closed economic models.
So let’s applaud and support the work of these pro-privacy cryptographers. They are building out a core feature of our future digital economy’s infrastructure, one that’s needed to both protect human beings and enable exchange among them.
Globe image via Shutterstock.