The basic Bitcoin system as it’s used today is in essence pretty simple: it’s a distributed contracts ledger storing all the transactions (with a bit of pruning). Yet it has lead to a wild ride where stunning amounts of hard cash are exchanged for numbers in this abstract ledger. In May 2010 a pizza was bought for 10,000 BTC. By January 2013 bitcoins were trading at $10 each. In December 2013 they exceeded the price of gold. With all these crazy numbers it’s easy to focus on just the bitcoin (i.e. the currency) price speculation and ignore the bigger picture. Bitcoin blockchain transactions are far from being limited to simple A-to-B transfers. They can contain much more information, such as multiple payers, multiple payees, and rules on the signatures required for a payee to collect. There are even time locks that dictate how long a transaction can be valid. This allows quite sophisticated systems to be constructed, such as escrow agents for customer/merchant dispute resolution, co-signatories to accounts, time-limited deposits and even the equivalent of post-dated cheques. All of this sophistication is part of the Bitcoin system itself and requires no central authority.
All this is by itself is enough for a revolution in the finance industry, eliminating a whole class of payment intermediaries. But an even more radical change can be seen if we step back and look at the Bitcoin system itself in a different way. We can separate the bitcoin currency from the underlying system by realizing that the currency is the just the first ‘app’ to run on the Bitcoin system, and there can be more. Just as with the launch of the iPhone, the built-in apps are soon eclipsed by those that come from innovation the system unleashes. The key reason for this is that Bitcoin allows ‘permissionless innovation’ – where the only thing holding someone’s idea back is their own imagination (OK, so Apple’s app store rules hold people back too, which is why there aren’t any bitcoin wallets on iPhones, but I digress). The internet itself is the best example of permissionless innovation. In the mid-90s it was far from clear the internet was going to be so important (Krugman said that the internet would have no more impact than the fax machine), and most people were using a network called CompuServe (derided at the time as Compu$erve for being so focused on money). But to add something fundamental to a proprietary system requires agreement from the owner. And anyone who has tried to get large corporations to do something new will tell you just how easy that isn’t. This is why I think Bitcoin, warts and all, is the future for financial systems: because it’s here today, it works, and anyone can join in and do stuff with it without getting permission from some central authority. And I think that colored coins is one of the most exciting things that will be done with the Bitcoin system.
The concept of colored coins uses the Bitcoin system to store and manage the ownership of assets outside the Bitcoin system itself. These might be anything from shares to cars. The idea is that a particular bitcoin is ‘colored’ to signify the ownership of a particular asset. Because the block chain is public it is possible to then track that bitcoin ownership through all the transactions involving it and to derive the current ownership. The number of bitcoins included in the transaction is purely a token amount so a tiny value can be used, a little like writing an IOU for a car on a dollar bill and then storing it in a wallet designed to hold dollar bills.
Each particular coloring scheme has its own rules on how it interacts with Bitcoin, such as who is allowed to issue the colored coins, how they are redeemed, what type of transactions are permitted, etc. This is a flexible approach that even allows organizations to cooperate on a shared scheme (for example, a group of airlines jointly issuing flying points that can be redeemed, with the airlines outsourcing to Bitcoin the trading of those points). This is a big change in the way such schemes are run: the network is decentralised and can be used so that no single entity has control and so there is no opportunity to block competition and extract monopoly rents.
One really interesting use for coloured coins is for smart devices to connect up to the Bitcoin system. Today a box that streams movies from the internet must connect to a central server (e.g. the iTunes servers) to implement Digital Rights Management (DRM) to check what movies a user has bought before playing them. This means the producers of a movie can only sell to the user through that central service. If the operator of that service shut down for whatever reason then the user is left without access to the movies they bought. This has already happened for music: in 2008 Microsoft announced it would shut down its MSN Music service (using its ironically named PlaysForSure DRM system) and that its customers would no longer be able to transfer their music to any new computers they bought (soon after, Yahoo torched its DRM servers too). The Ultraviolet system, a joint venture by several Hollywood studios, is an attempt to do a better DRM system where the control of the central DRM server is wrested from the grasp of a single entity like Microsoft and put under the control of a group of companies. But Bitcoin could be better still: colored coins for movies would step around any need for a proprietary central DRM system: the blockchain would hold the entitlements. A customer’s video player could look at the blockchain directly (by embedding a Bitcoin client into the firmware of the player) to see what movies its owner had bought and then could prove to any server storing the movie that they were entitled to play it. The full features of Bitcoin transactions could be then used, enabling a movie to be rented, sold, re-sold, loaned, and so on. The issuer of the coloured coin for a movie would be the movie studio and they would control the terms of the market for their own movies (perhaps demanding a ‘droit de suite’ fee when it was transferred). Because the rules of the scheme would be open and transparent and the ownership rules (such as requiring the issuing studio to countersign transfers) embedded directly into the blockchain it would then be possible to define just what ‘ownership’ of a movie means. This would allow a proper market to develop and over time a proper balance between the rightsholders and consumers would be struck (and instead of the courts ruling on what Bruce Willis can do with his music it would be the transactions in the Bitcoin blockchain that made it clear).
The use of colored coins on top of the Bitcoin network is a bit of a kludge and obviously it would be better engineering to design something to support colored coins in a more direct way using a new Bitcoin-like network. But generally speaking things that work right now are preferred to grand things that will work in the future. While Al Gore was talking about the Information Superhighway we had the wheezing dialup modem internet much mocked in Doonesbury cartoons. But it was the internet that actually became that superhighway. Similarly, the Bitcoin network exists today with its thousands of specialist transaction processing computers worth a fortune and so there is nothing to stop companies using it to introducing new products and services right now.
Colored coins will likely follow the trend that started with the internet to weaken the power of intermediaries in markets. So much of the finance industry today is predicated on trusted central services for trading, for asset registers and for clearing. With a public blockchain and decentralized trading, the Bitcoin network has the potential to shake things up. Imagine a company issuing its own shares as colored coins: the ownership and trading of those coins is taken care of by the Bitcoin system, so what will existing organizations do? Will registrars offer ancillary services (e.g. for collecting dividend payments on behalf of an shareholder)? Will nominee services disappear? Will new ‘low cost’ venues emerge for trading small business shares by cutting out a large part of the cost of IT infrastructure? Predicting how this will shake out is a fun game, and this ‘wargaming’ is something that venture capitalists are going to be playing a lot in the near future.
My thoughts on Bitcoin, colored coins and DRM were previously published in the 13th December 2013 issue of MoneyWeek magazine. If you liked this post here’s the address of my tip jar: