Bitcoin Reviews

Maybe reviews at some point, but for now just some posts about Bitcoin…

Colored Coins Questions

One of the more interesting ideas to come out of the cryptocurrency community is the concept of colored coins, in which units of an asset (e.g. shares in a company or units of a fiat currency) are represented by small fractions of a Bitcoin. Decentralized, transnational stock exchanges, commodities exchanges and currency exchanges have all been envisioned with colored coins. Unfortunately, while there are a few technical issues that have stood in the way of colored coins projects, I believe there are more fundamental issues that will limit the market for the concept.

From a technical standpoint, one obstacle has been the necessity to track a colored coins history in order to verify its validity. This makes it unworkable for colored coins to work with Bitcoins standard simplified payment verification (SPV) mode, where a single request can check the balances of many addresses. For colored coins, in a worst-case scenario, there could be an exponentially growing set of addresses in a coins history that would need to be queried for in series. If colored coins became widely used, it would likely be necessary for users to trust centralized indexing services or to run resource-intensive full nodes.

Another technical problem for colored coins is that they create a potential mismatch between the amount of value protected by the Bitcoin blockchain and the incentives provided to miners. Normally, as Bitcoin appreciates in value, the incentive to supply mining power increases with the value of the bitcoins. With colored coins, however, the appreciation of colored coin assets does not increase the incentive for miners. At some point, if there were a sufficiently large value of colored coin assets, the value of the colored coins could be worth far more than the underlying Bitcoins. This could invite a 51% attack. It would also be very difficult for the community to adjust block rewards and mining fees to account for the value of colored coins while maintaining an efficient fee and inflation structure for the currency application of Bitcoin. Because of this, I believe colored coins could have negative effects on Bitcoins security and scalability.

Despite the technical obstacles to the success of colored coins, I believe there to be a more fundamental problem, which is that colored coins require trust in counterparties and asset issuers, and those counterparties and issuers are subject to the rules and regulations in their home countries. Colored coins theoretically allow distributed, private exchanges, but an issuer based in the U.S. is still responsible for making sure its shareholders and exchanges are compliant with the all of the same SEC or CFTC regulations as a traditional exchange. More and different regulations would apply to colored coins issuers or exchanges serving the EU, Japan or other countries.

Whereas Bitcoin is transnational and censorship-resistant because there is no counterparty for a Bitcoin, colored coins do not have those same properties. Colored coins provide a different kind of asset database, but that database offers little advantage for financial assets as far as transnational exchanges or censorship-resistance are concerned. (Applications like smart property or digital assets could be more promising.)

Assuming the technical obstacles were solved, the potential markets for colored coins would be 1) Assets whose issuers reside in foreign countries without securities regulations. 2) Assets whose issuers who are willing to personally risk suffering the consequences of regulatory violations. 3) Asset types that are not regulated. 4) Assets whose issuers are able to remain completely anonymous. 5) Assets issued by decentralized autonomous corporations.

In the first three cases, there is little advantage to using colored coins vs. a traditional centralized asset registry database. The latter two cases are clearer use cases for colored coins, but so far, there are a very small number of assets and issuers that fall into those categories. Because of this, while I believe the concept of colored coins to be novel and innovative, I believe the current financial applications to be quite limited.