Colored Coins: Bitcoin’s Specter Haunts Capital Markets

At R3, our team of engineers are in constant collaboration with the financial services professionals at our 42 member banks.  Most of our work entails marrying requirements with development execution to satisfy the standards of our consortium.

Though we cannot claim a monopoly on expertise in distributed ledgers or capital markets, we have begun to eliminate certain approaches to any financial-grade software solutions. Upon examining the distributed ledger landscape, we’ve found that the most saliently unsuitable application of distributed ledger technology is also one of the most popular: colored coins.

Colored coins are Bitcoin transactions which carry particular meanings. Since every transaction is traceable in Bitcoin, you can designate certain coins and say that each one represents an asset. Transaction participants can then trade each coin with purported finality.

In their original conception, colored coins inherited all of Bitcoin’s properties. For capital markets applications, this is problematic since Bitcoin’s cryptocurrency design is optimized for an open system where anonymous participants are potentially hostile. Bitcoin employs some unique design choices, such as anonymous consensus for miners and a purposefully costly transaction validation scheme, to achieve this feat. Bitcoin provides users with a number of features, yet many of these features become redundant if a required solution does not want to resist censorship.

In private applications of colored coins, the code base can be amended to engineer away less desirable features in Bitcoin. It’s our belief, however, that patching over a codebase built to power a censorship-resistant cryptocurrency is not the basis of any serious application in capital markets. Standardizing on a colored coin solution despite its origins betrays a desire to get to market as fast as possible, which is bound to happen at the expense of quality.

 Colored Car...or an alternate development of the trucking industry inspired by colored coins

Colored Car...or an alternate development of the trucking industry inspired by colored coins

Colored coin solutions replicate the “move fast and break things” attitude common to Silicon Valley rather than being designed in a way that best addresses the problem they seek to solve. The multiple hacks on Bitcoin exchanges through the years attest to the inadequacy of this approach when millions, let alone billions, of dollars are at stake.

Executives don’t need to be ace developers to intuit why colored coins are insufficient for financial services software applications. A software which proposes to transform the capital markets infrastructure ought to be built from the ground up with the needs of institutions in mind, not retrofitted from another code base. Even if developers of colored coin solutions find hacks to patch deficiencies in Bitcoin’s code when creating a capital markets application, it seems nonsensical to trust the development of critical infrastructure to developers which opt for tweaking over building.