Monday, June 8, 2015

Colored Coins are here

Last November I wrote an "explainer" for Coin Center on the topic of colored coins. The basic gist of the article is that Bitcoins are a digital commodity which can be traded themselves and have a market value, but they're also a bit like blank piecea of paper. Any other financial instrument (cash, equity, debt, REIT, etc.) can be printed on them, and then traded via the blockchain. Back when I wrote the article this was more theoretical than practical, but technology and business have advanced in the last seven months. A few items-

NASDAQ has announced an experiment with private company stock on the blockchain. This means that private companies, when they issue shares to employers or early stage investors, will do so by sending the shares to a Bitcoin wallet that is colored coin compliant. The employees can also redeem their shares, or trade them on authorized secondary markets, using the same technology.

Overstock has issued their first debt instrument on the blockchain. The debt issuance this time around is limited to accredited investors, but that's a restriction of the US securities laws, not the technology. If this proves successful as a means of debt issuance, a very large market could be captured by bitcoin.

LHV Bank in Estonia has issued Euros on the blockchain. These bank obligations are supposed to be a cash substitute for local payments, to directly compete with the credit and debit card networks. Although technically not cash (because only the European Central Bank can issue Euros, and they haven't issued any to the blockchain) this instrument is probably most usefully thought of a money market fund share that trades at par. It's 1 Euro. According to the lead developer of this project, this is currently in a test phase with only 100,000 EUR in liquidity.

These are significant developments for the Bitcoin network, and address one of the key issues with widespread adoption. Among the issues that currently put Bitcoin at a disadvantage relative to the card networks or bank payments, are the volatility of the bitcoin price and the need to trade out of the bitcoin network after each transaction in order to have a currency that's commonly accepted in your local economy. With colored coins, both of those objections go away. Colored coins use only a de minimus amount of Bitcoin (fractions of a penny) to mark their value on the blockchain, so their market value is always equal to whatever financial instrument they represent (1 Euro, a $1000 bond, etc.). When you receive 53 Euro via colored coins, you have 53 Euro, and that doesn't fluctuate in your local currency (Euros).

Volatility - gone.

Need to trade off of Bitcoin to get a useful local asset - gone.

Further, colored coins keep the primary benefit of bitcoin transactions, which is irreversibility. When a merchant accepts bitcoins, it's just as much his as if he accepted cash. The customer may seek a refund for some reason, but that refund will be decided by the merchant or a Court of law, not the credit card processor. This produces a great deal of certainty which will be very attractive to merchants. "As final as cash" is a good marketing slogan for merchant adoption.

The two remaining stumbling blocks, as I see it, are privacy and fast transaction time. Let's deal with the second of those issues first.

Credit and debit card networks confirm their transactions fairly quickly, usually on the order of a few seconds (ignoring the chargeback issue). Bitcoin blocks are only confirmed on average every 10 minutes, and you want at least three confirmations to be fairly certain the transaction is accepted. This is probably fine for selling your privately held equity back to your employer, as in the NASDAQ example above, but it's obviously unacceptable for everyday shopping at the grocery store or pub.

Thankfully I think this issue will be solved thanks to the Lightning network. I'm not sure how long it will take the Lightning network to become active, but a lot of the core devs support the initiative and Cuber (the company behind LHV's Euro coins) plans to support it as soon as it's up and running. I consider this "fairly certain".

As for privacy, I'm not sure how to get there. The current network of banks and credit card companies isn't private from the banks or the government; they can see what you're doing. But at least your friends and neighbors can't. On Bitcoin, anyone can explore the blockchain. Here's the transaction for the first Overstock debt issuance, to their CEO. There are Bitcoin tumblers which provide some level of anonymity, but I'm not sure how they'd work with colored coins. You'd at least need a very liquid market in the instrument you're trading for it to work, which I guess is feasible for cash but I'm not sure about the other less liquid instruments. Those may just be a public record.

But be that as it may, I'm quite fascinated by the developments here. Essentially since the invention of banking in Venice, over-the-counter trading has been limited to bearer instruments (rare) or between banks. The idea of regular folks exchanging cash and other assets directly, over the Internet, without any institutional intermediary, and for only a nominal fee (fraction of a cent), is truly revolutionary. Not to be excessively hyperbolic, but this really will "change everything" about finance. It's a very exciting time to be alive.

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