Litecoin and the fungibility problem of ‘tainted’ crypto

As the capacity of firms like Chainalysis and Elliptic to identify individual cryptocurrency bad actors continues to increase, the actual coins used in their dirty deeds can also be identified — negatively affecting their fungibility. It’s a problem Litecoin founder Charlie Lee says must be addressed.


Litecoin creator Charlie Lee has publicly stated that Confidential Transactions (CT) are on the way for the popular digital currency. In his announcement tweet, Lee makes the connection between sound money and fungibility. Fungibility is the quality of an item that makes it identical to another of the same kind. That means that one unit of a good is changeable for another.

In economics, fungibility is considered one of the essential qualities of sound money. Lee states: “Fungibility is the only property of sound money that is missing from Bitcoin & Litecoin. Now that the scaling debate is behind us, the next battleground will be on fungibility and privacy.”

Confidential Transactions (CT) refer to a protocol that obscures the amount and the receiver’s address. The protocol was first seen in privacy-centric coin Monero.

While most people are aware of the importance of Confidential Transactions in protecting user privacy, what they may not be aware of is that CTs are also very important for upholding the fungibility of digital currencies.

Dirty money isn’t (as) fungible

The fungibility of units of cryptocurrencies has become a major concern in light of the increasing success of blockchain analysis firms at uncovering the identities of individuals behind certain ‘suspect’ addresses.

Blockchain analysis is important in scenarios where criminal activity is suspected and the findings are based on tracking the units used in the alleged nefarious activity. In the case of an exchange hack, for example, blockchain analysis might be engaged to identify who owns a wallet address where stolen coins have been sent.

However, while blockchain analysis reports might be able to identify an individual behind criminal activity, the reports will also result in the branding of the coins used in these transactions as ‘tainted’ coins.

A good way to think about this is, it does not matter to you if the bank issued fiat currency currently in your wallet once belonged to a famous actor, say Sean Connery, or an infamous figure such as Pablo Escobar. The previous holders of the note do not affect your ability to use the currency, neither does it affect the willingness of a provider to accept the note as payment for goods or services. Banks try to destroy this fungibility by putting exploding dye packs in cash stolen during a bank robbery. If the pack goes off the cash is covered in blue dye – making it essentially unspendable.

On some networks, such as Bitcoin and Litecoin, it is possible to view the history of every unit spent. As a result, coins stolen in an exchange hack, for example, are identifiable – with many members of the cryptocurrency community trying to avoid this ‘tainted’ currency. In fact, the undesirability of tainted coins has even led to the rise of a market where miners sell brand new bitcoin units, but at a premium.

Other methods being utilized in order to mitigate this emerging challenge include the creation of a whitelist. This is a list of coins whose history has been thoroughly scrutinized.

While these are interesting responses to the problem, it can also be viewed as a design challenge. If networks can find a way to obscure the amounts and other aspects of transactions, while still retaining the other features inherent to their blockchains and without compromising the security of the network, then the challenge is negated form the ground up.

Evidently, Lee also believes fungibility is an architectural issue. Moreover, it seems that he views Confidential Transactions as the tool through which this can be achieved on the Litecoin Network.

He tweeted: “I am now focused on making Litecoin more fungible by adding Confidential Transactions.”

The proposed timeline

Lee was vague on the specific launch date of Confidential Transactions on Litecoin, saying only that they will be added to the network sometime in 2019. He did state that the upgrade would not require a hard fork. Instead, Confidential Transactions will be appended to the network through a soft fork.

Following the announcement, many in the community believed the change would come through the MimbleWimble Protocol. MimbleWimble is a privacy-enhancing software, which was developed by Tom Elvis Jedusor. While MimbleWimble is an innovative protocol, it has its limitations. Lee stated: “Too hard to do MW. It changes the blockchain too much and has to be a hard fork”.

Additionally, Lee intimated that the upgrade may borrow heavily from the Elements Project developed by Blockstream.

Elements is an open-source sidechain platform for the Bitcoin network. The sidechain supports many innovative features not inherent to the Bitcoin blockchain while maintaining the celebrated characteristics of the network, including Confidential Transactions and Issued Assets.

Lee further revealed that the privacy features would initially be opt-in. This is similar to how privacy works on ZCash, whereas on Monero, privacy is mandatory.

Lee acknowledges, however, that privacy features work better when the entire network participates and that the Litecoin network will eventually go on to have mandatory Confidential Transactions. He did add that there were concerns such as block size which would have to be considered as well during and after implementation.

The significance of this announcement

Although a top 10 digital asset in its own right, Litecoin is widely considered as a testing ground for upgrades to be added to the Bitcoin network. Litecoin is very similar in specifications to Bitcoin. The altcoin was designed by Lee to be the digital silver to Bitcoin’s digital gold. Thus, the two networks are identical in many ways.

For instance, when Litecoin was able to successfully upgrade its network with Segwit, it became apparent that the software was stable enough to be integrated into the bitcoin network.

Despite a widely held impression to the contrary, Bitcoin transactions are not currently confidential. Therefore, if Litecoin adds CT to its network and the upgrade is stable and does not reveal any underlying security problems, then Bitcoin may soon also be on its way to achieving true transactional privacy.

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