Sanctions, censorship, and ESG: Is Bitcoin still fungible?

With governments in Russia and Canada sanctioning specific crypto addresses, concerns arise over the slow erosion of Bitcoin's fungibility.
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With governments in Russia and Canada sanctioning specific Bitcoin addresses, many people want to know: is Bitcoin really fungible?

A synonym for fungible is “interchangeable.” Common pennies are interchangeable — each worth one cent of repayment for all debts, public and private. Swapping one penny for another does not affect their value.

The 18.9 million BTC ($778 billion) in the world are commonly considered fungible. With a valid signature signed by a private key, no one has ever been able to stop a user from sending their Bitcoin to anyone.

In this sense, Bitcoin’s network is perfectly censorship-resistant.

However, custodians like fiat ramps (both on and off) introduce chokepoints that operate outside Bitcoin’s network.

Custodians and service providers who control the private keys of others are subject to sanctions and court orders. They must comply with specific directives under threat of financial or criminal punishment.

With this in mind, are Bitcoins fungible? Sure, a valid signature may always move BTC on-network.

The blockchain does not worry whether Bitcoin was acquired through criminal means (like ransomware) and treats all BTC and private keys equally.

Chainalysis’ API threatens the fungibility of all crypto

Fungibility has been a significant selling point for Bitcoin. It’s a crucial characteristic of enduring stores of value throughout history. Other qualities include portability, durability, divisibility, scarcity, and verifiability.

What about a real-world transaction, like selling Bitcoin for dollars or requesting a custodian move one’s sanctioned Bitcoin?

Like gold, Bitcoin is a bearer asset. Bitcoin is fungible and censorship-resistant within Bitcoin’s network. Still, sanctioned wallets will experience roadblocks depositing BTC with a custodian that complies with sanctions.

In the context of off-network service providers like Coinbase, Bitcoin’s ‘perfect’ fungibility might be overrated.

The world’s largest independent blockchain analysis company, Chainalysis, recently introduced an API for crypto exchanges to check digital asset deposits against lists of sanctioned wallets.

Chainalysis expects to release this API publicly in April. The New York-headquartered firm regularly does contract work for US government agencies.

It also released an on-chain oracle for operators of smart contracts to check whether the US Treasury’s Office of Foreign Assets Control (OFAC) has flagged a crypto address interacting with their smart contract.

Chainalysis is in the business of flagging and tracking criminally-linked Bitcoin.

Decentralized applications can use these tools to improve compliance with regulations and sanctions. This will also reduce the real-world fungibility of crypto assets — Bitcoin or otherwise.

Chainalysis demonstrated its ability to analyze transaction data on blockchains to inform criminal prosecutions, including New York residents who now face charges related to their alleged roles in the 2016 Bitfinex hack.

It could be that Chainalysis’ upcoming API leads to more Bitcoin flagged as criminally-linked. But the US government frequently auctions off seized Bitcoin.

From that point, the ecosystem considers that crypto entirely fungible and no longer tainted (take heavily-eyebrowed investor Tim Draper’s acquisition of Ross Ulbricht’s Bitcoin, for example).

Bitcoin’s fungibility less problematic than Monero, Zcash

Because forensic analytics companies like Chainalysis can so readily trace Bitcoin transactions, prominent Washington DC think tank Brookings recommended regulators focus on other cryptocurrencies.

Bitcoin is easy to trace and sanction; privacy coins like Monero and Zcash are not.

Regulators are already paying attention to these privacy coins. Exchanges like Bittrex already dropped listings for privacy coins like Monero and Zcash due to pressure from regulators.

The IRS even offers bounties for cracking the privacy mechanisms of these cryptocurrencies.

Regulations require financial institutions to implement know-your-customer and anti-money laundering (KYC/AML) protocols and forward details of certain transactions.

US law requires most financial institutions to report deposits and withdrawals worth more than $10,000, for instance.

These reporting demands caused people like Edward Snowden to express concern about the dragnet-like surveillance of private citizens’ lives.

Even privacy service Wasabi now censors some transactions, eroding Bitcoin’s fungibility on that service.

Read more: [US government spooks have cracked ‘anonymous’ Bitcoin wallet Wasabi]

Fully decentralized applications like decentralized exchanges might also refuse to implement Chainalysis’ new tools due to their ongoing opposition with regulators in favor of privacy rights.

One instance is ShapeShift, which eventually became a decentralized exchange. Once centrally operated, it returned to more private operations to avoid KYC/AML requirements.

Law enforcement agencies, of course, don’t like this very much because it means they have to do more leg work to track down possibly illicit crypto transactions.

Crypto miners wanted to sell ‘green’ Bitcoin for 10% markup

Indeed, most centralized exchanges have more to lose by defying regulators. If their founders or operators are known by name, a process server can serve them with legal documents.

Absolute privacy advocates use mixers and coinjoins to break forensic traceability between transactions.

  • Ironically, mixers take advantage of the reality that Bitcoin is fungible.
  • Those interested in mixing their coins may use a third-party mixer.
  • This comes with risk of becoming a target for law enforcement.

In February 2020, the Department of Justice charged Helix founder Larry Harmon with conspiracy to commit money laundering and running an unlicensed money transmitter. He had operated Helix as a darknet mixer.

All these scenarios relate to criminality and government sanctions.

In mid-2021, as investors experienced the first thrusts of ESG-mania (which stands for Environmental, Social, and Governance), some opportunistic Bitcoin firms began toying with selling so-called “green” Bitcoin.

Shark Tank guy Kevin O’Leary is pushing the idea that “green” Bitcoin will one day trade at a premium.

Read more: [Bitcoin miners go nuclear in the hunt for cheap electricity]

“Green” Bitcoin is cryptocurrency mined with renewable energy rather than fossil fuels. Some miners were banking on selling these tokens at a 10% markup on “standard” Bitcoin.

It’s unclear if that trend is actually materializing, although many Bitcoin mining companies have pledged to transition away from fossil fuels altogether.

So, to answer the question, “is bitcoin fungible?” It certainly is the protocol layer, less so at the social layer.

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Out now: the first three episodes of our new investigative podcast series Innovated: Blockchain City.