The debate on the fungibility of Bitcoin
For several months, the small world of cryptocurrencies and blockchain experts have been discussing the fungibility of Bitcoin. The debates are quite passionate. But why are we wondering about the fungibility of Bitcoin? And what are the issues of this debate? On this last point, the answer is not always clear, but most commentators consider that the future of Bitcoin, especially as a payment method (or cryptocurrency) goes through a perfect “fungibility”. What does this mean? The essence of Bitcoin, namely the traceability of all transactions and their history. Most commentators believe that this total traceability is detrimental to the “fungibility” of Bitcoin insofar as an increasing number of stakeholders (trading platforms, merchants, etc.) refuse Bitcoins that have been used previously for the purchase of illegal or illicit goods or services (such as the purchase of drugs or weapons on the Silk Road site or other equivalent sites). Or if they are not refused, a reduction on the value of these “tainted” Bitcoins is applied. In fact, behind this technical debate[1], it is the whole question of the operating mode of public blockchains which is at stake. Another way to approach the issue is to consider it from a legal perspective in civil law. When we talk about the fungibility of Bitcoin, what exactly are we talking about?[2]
One way to try to answer this question and start from a concrete case is to examine the Bitcoin loan. How can the Bitcoin loan agreement be qualified? What should the borrower repay, in particular when Bitcoins have been forked?
What is a fork?
A fork is an operation during which the computer protocol of the Bitcoin (or any other cryptocurrency) is revised by some of the users after a democratic consultation but, at the end of which, the absence of consensus leads those who refuse this change to continue using the old protocol, and those who accepted to use the modified protocol. This was the case in 2017 (but it is not the only one) between the initial Bitcoin (BTC) and Bitcoin Cash (BCH). This division consists in the creation of a new operating mode for the issuance of a new Bitcoin and the validation of transactions[3]. The new units are managed differently, have a different name and code and their own exchange rate against other fiat cryptocurrencies or fiat currencies. At the time of the fork , Bitcoin owners were assigned the same number of Bitcoins Cash as the original Bitcoins (BCH) they held[4].
After borrowing Bitcoins, what should the borrowers return to the lenders? Only original Bitcoins (BTC)? Or a combination of Bitcoins Cash (BCH) and original Bitcoins? It is the legal nature of Bitcoin that will answer the question of repayment on the maturity of the loan and the risks borne by the borrower or lender in case of alteration of the loaned property.
Fungibility and consumptibility of Bitcoin
The whole legal question in civil law is whether a Bitcoin is a “specific thing” or a “thing which cannot be individualised” of the category of goods. Part of the difficulty lies in the dual nature of Bitcoin: a monetary unit that brings it closer to the currency without, however, being qualified as legal tender, but also an asset, the object of transfers and transactions. Without going into the debate about the legal nature of digital goods, Bitcoin can be equated with intangible property or digital goods. This means that Bitcoin can be the subject of a possession — or even of an ownership. Evidence of this still needs to be determined — but that is another debate.
In order to determine which loan regime (with or without transfer of ownership) applies in the case of Bitcoin, it must be examined whether it meets the criteria of consumptibility and fungibility.
Bitcoin is not naturally consumable (Bitcoin is not naturally destroyed); however, it is consumable because of its use (in the same way as legal tender, Bitcoin is “spent” when it is used).
Is Bitcoin fungible[5]? Fungibility requires an equivalence between two things of “the same kind and quality”, according to the expression generally used in civil law. A kilo of potatoes is fungible with another kilo of potatoes provided that it is the “same kind and same quality” of potato. Thus, potatoes that have sprouted will not be of the same “quality”, and therefore will not be fungible with other potatoes of the same “kind”. The same applies for a pot of yoghurt. A pot of yoghurt which has passed its expiry date is not of the same “quality” as all other yoghurts of the same “kind” (here, the existence of a batch number on each yoghurt does not make the yoghurts less fungible between one another). We can see that fungibility is often linked to the expiry of a living product. However, fungibility can also apply to non-living things. Bitcoins have no lifespan. The fungibility referred to is not related to any expiry but to a modification of the very substance of Bitcoin, which constitutes its “DNA”, in this case the computer protocol that created it.
Does the fact that it is possible to trace the history of Bitcoins lead to making them non-fungible? The argument put forward by cryptocurrency experts is that in the early days, Bitcoins may have been used for criminal purposes, which led to them being refused by some users.
For our part, we consider that the history of each Bitcoin via the chain of past transactions does not constitute an “individualisation” of the thing in the legal sense, even if it allows to trace the different users of previous Bitcoins, and thus hunt down fraudsters and other malicious users[6]. In this sense, the traceability of Bitcoin through the transaction history allows even more rigorous monitoring than the banknote numbers affixed to notes and which make it possible to know if these notes were stolen or not. The absence of face value, a centralised issuer and an individual identification are elements that distinguish Bitcoin from the banknote. So, why would Bitcoins be fungible? Because all Bitcoins are of “the same kind and the same quality” according to the legal term defining fungibility in the sense that Bitcoins are all from the same computer protocol and they are subject to an equivalence ratio with other goods allowing a payment to be made. Just as a merchant may refuse to accept a (very used) banknote, a merchant may also refuse to accept a Bitcoin whose history demonstrates illegal use. Certainly, within the framework of Bitcoin, it is not possible to go to the issuing institution to change one’s used note against a new note. But the fact that the note is damaged does not in itself affect its fungibility, in the same way that a Bitcoin with doubtful history does not affect its fungibility.
Thus, in view of the nature and modes of use of Bitcoin and cryptocurrencies in general, a Bitcoin loan will be the subject of a transfer of property to the borrower for the duration of the loan. Accordingly, at the end of a loan on a fungible thing, it is an “equivalent restitution” which must be made, which, in the framework of a loan of Bitcoins, results in the return of Bitcoins from the same protocol (and not of “forked” Bitcoins).
Ultimately, the debate on the fungibility of Bitcoin is poorly stated: less than fungibility, it is traceability which is at issue in this discussion. The legal fungibility of Bitcoin cannot be challenged.
[1] https://bitsonline.com/on-the-matter-of-fungibility-making-bitcoin-a-true-currency/
[2] For a vision of the subject in US law, see https://www.finregreform.com/single-post/2018/05/08/davis-polk-blockchain-bulletin-cryptocurrency-dlt-newsletter-3/
[3] Fork cases are becoming increasingly common in blockchains. A distinction is made between the ‘soft fork’ and the ‘hard fork’. The first is a modification of the protocol which remains compatible with the old blocks validated. The ‘hard fork’, on the other hand, is a major modification of the protocol, the interest of which is to be able to revise any aspect of the Blockchain code, but whose new rules are not compatible with the previous ones, thus being able to provoke a split between the different participants and the creation of a new Blockchain. Here, the entire chain of blocks is cloned. This duplicates the complete history of its transactions and all their elements. This is the case of Bitcoin Cash.
[4] “Forked” bitcoins had exactly the same serial number and UTXOs as non-“forked” bitcoins.
[5] Cf. in US law an excellent article on the subject: “The Problem of Digital Asset Fungibility”: Davis Polk Blockchain Bulletin, May 2018.
[6] The non-legal literature on Bitcoin confuses fungibility with anonymity in this respect. The debate on the “fungibility” of Bitcoins and other cryptocurrencies is at the centre of many discussions, particularly in comparison with legal currencies. In fact, the traceability of transactions is confused with fungibility.
