● Intermediate Crypto Basics

Fungibility

8 minutes 8 months ago

The possibilities in financial technology have the potential to go beyond digital tokens. Cryptocurrencies allow us to record IDs, certificates, real estate information, and other crucial data about tangible assets on the blockchain. In the crypto sector, 'fungible' and 'non-fungible' are popular concepts. When engaging with financial technology or considering NFT investments, it's important to grasp the concepts of fungibility and non-fungibility.

What Is Fungibility?

Fungibility refers to the capacity to interchange one unit of a financial instrument with another unit of the same financial instrument. It holds true with physical currency when you exchange your dollar for someone else's. Yet, it’s different when attempting to trade a U.S. dollar for an Australian dollar, as they possess distinct values.

In trading, fungibility signifies the ability to purchase or vend the same financial instrument across two or more distinct markets. A financial instrument, such as a stock, bond, or futures contract, is deemed fungible if it can be procured or sold on one market or exchange and subsequently traded on another market or exchange.

Understanding Fungibility

For an asset to possess fungibility, it must hold a mutually accepted value and be readily exchangeable with other items of akin worth.

Several financial instruments display fungibility; some examples are stocks on diverse exchanges, commodities like gold and silver, and currencies. For example, suppose you obtain 100 shares of a stock on the U.S. Nasdaq and then sell the identical 100 shares of that stock on the London Stock Exchange. This leads to a net balance of zero shares (100 acquired and 100 sold), and then the stock qualifies as fungible.

In the broader context, most cryptocurrencies are classified as fungible assets. Consider Bitcoin, for instance, which is deemed fungible due to each unit of BTC being indistinguishable from any other unit. This equivalence extends to both quality and functionality.

Fungibility vs. Non-Fungibility

Money is another example of a fungible asset. When Person A lends a $50 note to Person B, it's not important to Person A whether the repayment involves another $50 note, as they are readily interchangeable. Similarly, suppose Person A is repaid using two $20 notes and one $10 note. In that case, the $50 received satisfies Person A.

Conversely, consider an instance of non-fungibility: when Person A lends their car to Person B, it's not acceptable for Person B to return a different car, even if it's the same make and model as the original car lent by Person A. Ownership of cars isn't fungible in this context, but the gasoline fueling the cars is fungible.

Assets like diamonds, land, or baseball cards lack fungibility due to their unique qualities that either augment or detract from their value. For instance, diamonds exhibit distinct cuts, colours, sizes, and grades, making them non-interchangeable and unsuitable for being deemed fungible items.

Similarly, real estate inherently lacks genuine fungibility. Even on a street lined with identical houses, each house experiences distinct levels of noise and traffic, exists in different states of repair, and offers unique perspectives of the surroundings.

Special Considerations

The distinction between fungibility and non-fungibility can be subtle. While gold is generally recognised as fungible (where one gold ounce is equivalent to another), there are instances when it is not. The introduction of unique serial numbers or identifying marks to otherwise fungible items can compromise their fungibility. Assigning distinct numbers to gold bars, collectibles, and other items makes it easy to differentiate.

The Federal Reserve Bank of New York provides gold custody services to central banks and governments worldwide, storing gold bars in its subterranean vault. Every gold bar in the vault undergoes meticulous weighing, and scrutinising of the refiner and purity markings to ensure alignment with depositor instructions. This process is vigilantly observed and documented. As the exact bars deposited into the New York Fed's vault are the very ones returned upon withdrawal, such gold deposits are not categorised as fungible.

The Bottom Line

In essence, fungibility refers to the ease with which a good or asset can be readily exchanged for another of a similar nature. Some fungible assets include currencies, commodities, mutual funds, and precious gemstones. Understanding the dynamics of fungible assets and their role in shaping your overall portfolio strategy allows you to make better investment choices.

Despite the fervour surrounding digital artwork and non-fungible tokens, experts advise investors to exercise prudence by thoroughly assessing whether venturing into this realm aligns with their strategy. Before engaging with any asset, you should research item scarcity, comprehend market trends, and grasp the potential risks and rewards.

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