Anonymous Money is Fungible Money

Courtesy of Alastair Berg[1]

Fungibility is a key characteristic of money.  This has long been taught to students in high school and university economics courses. A rational individual should be indifferent to exchanging one note or coin with another of equal nominal value, provided of course there are no transaction costs. some degree this characteristic holds true. Cash is still largely fungible. Yet as cash transactions become less common; more and more of the money supply interacts with the highly regulated financial industry; and new, non-fiat, money technologies rise in use, it is increasingly apparent that forms of money technologies differ significantly in their fungibility.

In a recent working paper ‘The identity, fungibility, and anonymity of money’ I argue that fungibility and anonymity are synonymous. Physical cash has traditionally allowed users to transact with a high degree of privacy. Trading with cash allows users to hide information, which they would rather not reveal to the world.  Financial information can be used to reveal a surprising amount about a person’s medical issues, sexual activities and personal preferences. Yet as the use of cash becomes less common in many societies, and individuals transact more and more via heavily regulated financial institutions, the veil of privacy that cash provides is lifted.

As I explain in my paper, understanding the history of money – its identity – is part of the calculus in any transaction which involves its use. Merchants and other users have an overriding incentive – for commercial and regulatory reasons – to know something about the currency they receive. Transactions where currency changes hands involve an ex ante promise that the nominal amount received might be spent in some future transaction(s). Users will seek to avoid receiving money they cannot themselves use in the future.

Many organisations are now subject to the requirements of financial regulatory regimes around the world which require them to understand the history of the money they receive. Anti-money laundering and counter terrorism efforts have seen most jurisdictions force their financial institutions to examine customer behaviour to an ever-greater degree. Australia is one such jurisdiction which mandates the reporting of ‘threshold transactions’ to financial authorities under responsibilities set out in the

In addition to anti-money laundering and anti-terror efforts, governments use financial regulation to maintain tax revenues. In Australia, starting in July of next year, businesses will no longer be able to accept cash payments over AUD10,000. These increasingly onerous regulatory mechanisms cause financial institutions to ‘de-risk’ and exit certain markets since they are unable to adequately assess the provenance of the money their customers wish to transact. Also, restrictions on the use of cash for transactions of certain sizes fundamentally alters its fungibility for those who wish to use it as a medium of exchange; the 10,000th dollar is not equivalent to the 10,001st. In general, this means that users of a highly regulated – or as we shall see later, highly transparent – medium of exchange have limitations as to the way in which they dispose of said currency.

New forms of money technologies raise interesting questions as to their fungibility. Cryptocurrencies, notably bitcoin, were explicitly created with the purpose of bypassing traditional financial institutions. Due to the ‘crypto-anarchist’ ideology associated with many early (and current) bitcoin users, this form of currency has long been associated with illegal behaviour in the eyes of governments and financial authorities. The perceived anonymity of cryptocurrencies is what critics see as an enabling factor in crimes such as tax evasion, assassination markets, drug trafficking and terror financing. Yet such criticisms fundamentally misunderstand the technologies upon which first generation cryptocurrencies operate.

Bitcoin is a ‘peer-to-peer version of electronic cash’ which allows users to transfer value without any financial intermediary. Itself built on numerous existing technologies, bitcoin combines asymmetric cryptography, peer-to-peer networking, a ‘proof-of-work’ consensus mechanism and game theory to solve the double spend problem; the bitcoin protocol prevents users from spending the same ‘coin’ twice without the need for a central authority to monitor user balances. The bitcoin data structure allows anyone with an internet connection to monitor a publically auditable and append-only ledger upon which bitcoin are transacted. And while the ‘pseudonymous’ addresses users use to receive payments provide some degree of anonymity, there are increasingly available techniques that allow for owner identification. Interested parties can, using web cookies, IP addresses, clustering techniques, as well as information provided to cryptocurrency exchanges, increasingly associate individuals with these bitcoin addresses.

What then does this mean for the fungibility of bitcoin? Already it is apparent that the ability to transact anonymously, and the fungibility of a medium of exchange, are closely related. Anonymous money is fungible money. Instances of discrimination towards bitcoin associated with illegal activity – even the perception of illegal activity – have been seen by some cryptocurrency exchanges. Coinbase, a large cryptocurrency exchange, has reportedly refused to deal in bitcoin which is known to be stolen, or involved in illegal activity.[2] There have even been circumstances of units of bitcoin being given a stamp of legitimacy; 144,000 bitcoin auctioned off by the FBI fetched a higher price than those sold on exchanges.[3] As a result, some users have developed new types of cryptocurrencies such as Zcash and Monero which obfuscate transactions, preventing others from correlating an individual from the financial activities.

Privacy-centric cryptocurrencies allow users to transfer value in a peer-to-peer network without revealing the provenance of the ‘coin’ they send, or any other financial information about themselves such as how much other currency they hold. ‘Privacy-coins’ like Zcash use a mathematical technique known as a ‘knowledge succinct non-interactive arguments of knowledge’ (zk-SNARKS), a type of zero-knowledge proof. A zero-knowledge proof allows a user to reveal that they know X, without revealing what X is. This technology allows a user to transact value across the internet without relying on a financial intermediary, while obfuscating any previous transactions their ‘coins’ might have been associated with.

The development and use of cryptocurrencies such as bitcoin, and privacy-centric cryptocurrencies such as Zcash, highlight the relationship between fungibility and anonymity. Paying for goods and services with money that lacks a visible ‘history’ can protect information one might want to keep private, while giving assurance to its recipient that they can use it in future exchange at face value. This relationship holds for all forms of money. As the history of money – its identity, or memory – becomes increasingly transparent, whether through regulatory imperative or via the distributed ledger upon which it is transacted, its acceptance as a medium of exchange is contingent on that history.

 

 

[1] Alastair Berg is with the RMIT Blockchain Innovation Hub in Melbourne, Australia

[2] Vorick, David. 2018. “Ensuring Bitcoin Fungibility in 2017 (And Beyond).” Coindesk. Accessed 22 April 2018. https://www.coindesk.com/ensuring-bitcoin-fungibility-in-2017-and-beyond/.

[3] Casey, M.J., and P. Vigna. 2018. The Truth Machine: The Blockchain and the Future of Everything: Harper Collins Publishers.

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