Fundamentals of Fungibility

Over the last few weeks, I have witnessed a surprising number of conversations that used the terms “fungible”, “tradeable” and “liquid” interchangeably. Hint: if you try to convince me to put money into your STO, but you do not know what a non-fungible token is, then it is unlikely we will ever end up in a business relationship with each other.

Let’s go with the Wikipedia definition for Fungibility:

In economics, fungibility is the property of a good or a commodity whose individual units are essentially interchangeable, and each of its parts is indistinguishable from another part.

For example, since one kilogram of pure gold is equivalent to any other kilogram of pure gold, whether in the form of coins, ingots, or in other states, gold is fungible. Other fungible commodities include sweet crude oil, company shares, bonds, other precious metals, and currencies. Fungibility refers only to the equivalence and indistinguishability of each unit of a commodity with other units of the same commodity and not to the exchange of one commodity for another, which is barter.

Cash as legal tender is fungible. It does not matter which 1,000 yen note I use to pay for goods, or if I use two 500 yen coins instead. The same is true for Bitcoin. Any Bitcoin (or strictly speaking, any unspent transaction output) is fungible. One Bitcoin costs as much as the next one. The line between fungibility and non-fungibility can be a thin one, and there could be certain exceptions, which we will cover at the end of this article if you bear with us.

In turn, assets are non-fungible if each has unique characteristics and they are therefore not interchangeable, just like the Barbapapa figurines in the title. I might trade you one Barbabravo plus one Barbabright for one Barbamama, but they are certainly all different. Cryptokitties are the prime example of non-fungible tokens on the Ethereum blockchain. As their website states:

Each cat is one-of-a-kind and 100% owned by you; it cannot be replicated, taken away, or destroyed.

In Ethereum terms, fungible tokens are defined in ERC20 and non-fungible tokens in ERC721. ERC1155 is a multi-token standard, in which each token ID may represent a new configurable token type. Please read further in the specifications if you are so inclined.

Tradeability

Any digital asset, or any asset for that matter, can be traded freely. You just have to find a counterparty for your trade, which can be difficult at times. So, often, a token is considered “tradeable” if it is listed on an exchange. It has been the function of marketplaces for millennia to aggregate supply and demand in one location to make the matching of buyers and sellers easier. A “tradeable” token in that sense is very different from a “fungible” token. Non-fungible tokens can be tradeable on a marketplace. Cryptokitties are being traded. You can buy Barbapapas on eBay.

Liquidity

Once a token is listed on an exchange, it does not necessarily mean there is a liquid market for that token, a market with sufficient “depth” of buyers and sellers. Many issuers or exchanges are engaging market makers or liquidity providers to quote prices for listed assets, and to ensure an orderly market. When you trade in an illiquid market, you want to trade with limit orders rather than market orders. For liquid markets with lots of depth on both the buy and sell-side, you can operate with market orders (unless you are moving large positions) and be confident that you get executions near the prevailing market price.

Exceptions to Fungibility

Cash remains the only anonymous, untraceable form of money that we have today (fans of ZCash, Dash or Monero might disagree). With many societies moving towards a cashless future, there can be a premium put on cash. In the so-called “Vancouver Model” (please see our report “The Dark Side of Cashless”), where Chinese money gets moved offshore, a premium is being paid for untraceable banknotes acquired from small-time drug dealers on the street.

Similarly, in certain OTC transactions, allegedly a premium is paid for newly minted Bitcoin (currently, every new block on the Bitcoin blockchain rewards the miner with 12.5 Bitcoin, an amount that will be halved again at some point in 2020), as these Bitcoin do not have a traceable transaction history.

Traditional Financial Markets

There is a lot to be said about how traditional financial market treat fungible and non-fungible financial products, or securities vs listed/cleared derivatives vs OTC derivatives. It seems I might have stretched your patience already to the limit — if you would like me to write more about this topic, please comment below, and we will do this in a future episode.

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