Tim Swanson Paper: Watermarked tokens and pseudonymity on public blockchains


Public blockchains including cryptocurrencies such as Bitcoin and Ethereum were designed around specific security assumptions, namely that the validating nodes called miners -- the participants that validate transactions and create blocks -- were unknown and untrusted.  To make it economically costly for these validators to unilaterally reorganize history and double-spend transactions, a process called proof-of-work was integrated such that any participant that wanted to change the transaction record (the ledger) would need to expend real capital to do so.

These pseudonymous networks were designed with the goal of securely moving a native currency (bitcoins and ether) which were themselves effectively sealed off and exogenous to the physical off-chain world.  Over the past 18 months, several efforts have attempted to link off-chain assets to public blockchains such as Bitcoin.  That is to say, the ownership and title to off-chain assets would be managed vis-a-vis pseudonymous mining participants.

To do this, a handful technology startups have applied two types of watermarking methods to cryptocurrencies such as Bitcoin; one is called "colored coins" and the other is "metacoins."  Together these "watermarked tokens" attempt to secure virtual representations of off-chain assets with Bitcoin mining equipment.

Recall these two networks above, Bitcoin and Ethereum, were designed with different participants and security assumptions in mind relative to the world of regulated finance.  Namely, the enablement of interaction between unknown, untrusted and ungated pseudonymous validators. 

Yet if a network is comprised of known and trusted entities with legal, off-chain obligations to fulfill, then you have a set of different security assumptions to build around.  And in the case of financial institutions, a feature such as proof-of-work via mining, which is currently core to public blockchains is an unnecessary and even redundant.

This paper explores several of the drawbacks and challenges of using public blockchains for securing off-chain titles and concludes that these types of networks are not fit-for-purpose for globally regulated financial institutions.