Fungibility is a characteristic of things with interchangeable units. A good is fungible if one unit of the good consistently carries the same value as all other units.
Fungibility is a desirable attribute for a variety of things, but it is needed for currency. If money is not fungible, each unit will have a different value, and it will no longer function as a medium of exchange.
Divisibility is a crucial component of fungibility, particularly for Bitcoin. Similar to how five $1 bills should have the same purchasing power as a single $5 bill, one bitcoin should have the same purchasing power whether it is split into one, two, or ten UTXOs.
Certain products may be more or less fungible than others; fungibility is not a binary characteristic of money. As a decentralized, apolitical currency, Bitcoin has attained a high degree of fungibility, and it typically trades at about the same price around the world. On occasion, however, political intervention, criminal activity, and technological variances have caused some bitcoin to be more or less valuable than others.
At the present time, bitcoin is not completely fungible, but this is likely going to change at some point in the not too distant future.
Because of the distinct meanings that each of these concepts carries, fungibility and liquidity should never be mistaken for one another. The ease with which one thing or commodity can be traded for other goods or fiat currency is what is meant by its "liquidity." In the case of fungible assets, one unit of the item must have the same value as another unit of the asset that is present in the same amount.
The easiest way for the vast majority of people to wrap their heads around the idea of fungibility is through the use of fiat currency. The fungibility of a 20 Euro bill is demonstrated by the fact that it can be readily exchanged for either two 10 Euro bills or four 5 Euro bills.
One of the distinguishing characteristics that identify Bitcoin and other cryptocurrencies as distinct from the conventional currency is their fungibility. Bitcoin, to the surprise of many, is not fungible in the same way that fiat currencies are. Even though the value of a single satoshi is identical to that of the next satoshi, each time bitcoins are moved from one wallet to another, a record of the transaction is added to the blockchain.
If Bitcoin were to totally lose its fungibility, its utility as money and currency would be diminished, and its acceptance as a form of payment for goods and services would be thwarted as a result of the constraints associated with doing so. The censorship-resistant quality of Bitcoin is dependent on Bitcoin's ability to be converted into many forms. Censorship becomes feasible, and bitcoin's decentralized nature makes it susceptible to being taken over if individual bitcoins can be effectively banned or judged "not bitcoin."
Thankfully, a number of Bitcoin privacy projects are working tirelessly to weaken the heuristics and assumptions that chain analysis companies use to attach taint to certain coins. These privacy-focused efforts are essential to the overarching goal of maintaining Bitcoin's fungibility and, as a result, its utility as a global, decentralized currency.
As governments continue to improve their surveillance capabilities, the competition between Bitcoin developers, surveillance companies, and governments is likely to intensify. At the same time, Bitcoin developers are building more powerful techniques to defend privacy and invalidate chain analysis heuristics.
Would you like to know how often blocks get added to the Bitcoin Blockchain? Read our blog to learn.