The Color of Money

Earlier, we discussed the concept of promises, and how fintechs should see themselves as being in the business of managing warehouses of promises, that is, managing promises between banks and clients on their behalf. But because promises are non-fungible, warehousing will require a new ledger semantics, one that will ultimately make auditing transactions easier and that provides greater protection for customers and other fintechs in the value chain.

In this article, let’s dive into the concept of fungibility, how the concept made its way into modern accounting, how it causes problems for modern ledgering needs, and the first steps we can take to modernize ledgering to account for non-fungible value (like promises).

A dollar is a dollar, except when it isn’t

Most of the time, we think of money as fungible. If I gave you a 5 USD note now, I am happy to accept a different 5 USD note from you later, or even five 1 USD notes. The specific note or combination of notes doesn’t matter to me so long as you repay me 5 USD.

But two 5 USD notes are definitely distinct physical things. At a very basic level, they will have two different serial numbers allowing for easy distinction. More fundamentally, they will be composed of distinct arrangements of cotton and linen cellulose fibers that we could observe under a microscope. Forensic specialists often use these facts about banknotes to assemble money trails that link individuals to crimes. The U.S. Bureau of Engraving & Printing has a very specific understanding of which notes are fungible and which aren’t for the purposes of replacing mutilated currency.

Fungibility: A helpful but overly simple assumption

In the end, the fungibility of money is a concept we impose on physical currency to remove friction from trade, and to facilitate the evaluation of liabilities and assets. Classical double-entry accounting practices treat money as fungible because it is concerned with describing the financial position of a business, rather than being an assets inventory system. Classical accounting wants to answer questions like: Are there sufficient assets to back the liabilities? Did the gains balance the losses, and if not to what degree were they unbalanced? Answering these questions requires an assumption that money—the measure of value—is all the same, that it is totally fungible.

Current digital ledgers evolved from classical accounting practices, and inherited the same set of assumptions. But the assumption of fungibility means that we lose some important information along the way connecting the ownership and possession of funds, information that we’ve seen modern ledgers need.

Consider a basic transaction, in which you deposit 100 USD into a fintech account. The fintech debits Bank A 100 USD, and credits you 100 USD. (If that seems backwards, well, that’s a common misconception.) Imagine this is the very first transaction for the fintech, which means it’s ledger now looks like this:

So far, so good, the fintech knows where your money is—it’s in Bank A.

But now I come along and deposit 100 USD into my account. This time, the fintech debits Bank A 50 USD, and Bank B 50 USD; it credits me 100 USD. Now the ledger looks like this:

The assets and liabilities balance, as they should. But we no longer know whose money is deposited in which bank. You might think this doesn’t matter—money is fungible, when the funds are withdrawn, the fintech can just take them from whichever bank account is convenient. But the key lesson of the Synapse collapse is that the ability to track this information is critical to the stability of the fintech world. Modern ledgers need to be able to answer questions about how the liabilities are connected to the assets, not merely whether they are balanced. Tracking the information necessary to answer these questions means we need to add some nuance to our assumptions of fungibility.

There are other scenarios in which the assumption of fungibility can lead to problems. Imagine a fintech that accepts transfers from banks it has a close working relationship with, as well as international transfers. Those local transfers are likely unproblematic, but international wire transfers come with all kinds of strings attached—the transfer might be reversed if the transmitting bank has reason to think it’s fraudulent, for example. So this fintech might like to track more secure deposits separately from less secure deposits.

The color of money

The ability to distinguish a given 100 USD from a different 100 USD is a concept we at Formance call the “color of money”. The idea is that in a modern ledger we should be free to annotate transactions with a set of arbitrary properties that allow us to distinguish which funds are fungible with which other funds, and with which they are not fungible.

In Formance Ledger, we represent a value of 100 USD to be transferred using this notation:

But it’s not hard to imagine ways to extend this notation to attach properties to these values:

In this abstract case, the annotations only tell us that the two bundles of 100 USD should not be treated as fungible, they have different property values—that is, they have a different color.

We can use color notation to draw the kinds of real-world distinctions we discussed above, for example to indicate the physical location of funds:

Or the quality of the money—whether the transfer has a risk of being reversed:

And we can combine these properties to make a compound color:

On the basis of the color we can then create custom fungibility rules. At the most basic level we could choose to say that funds are only fungible when all of their properties match—when they have the same color. And we can also create custom rules for transmuting funds with one color into funds with a different color—a topic which we will return to in a later article.

The color of money is a very powerful tool that opens the possibility of answering fine-grained questions about the specific relationships between assets and liabilities and how they are connected. For example, it allows tracing the physical movement of funds, connecting the bank accounts holding funds with the depositors of those funds, and knowing when a money from reliable and unreliable sources has been mingled.

Conclusion

It’s customary in classical accounting to treat money as fungible, because classical accounting is expressly for the purposes of evaluating the overall situation of a business—assessing its financial health, detecting irregularities and fraud, and providing tools for auditing and verifying any claims about the overall situation by looking at whether assets and liabilities are balanced. But taking cues from the industry issues that surfaced in the last couple of months, we make the case that fintechs need to be able to answer more detailed questions about how assets and liabilities are precisely connected. They need a ledger that allows them to completely track the movement and current location of funds, that forces them to be more careful about how those funds are moved and assessed. These requirements point to a need for a more nuanced understanding of the fungibility of money, and the ability to discern when one dollar isn’t the same as another.