R3 Group Paper: Colored-Coin Watermarking Won’t Secure Off-Chain Assets

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R3 facebook IBTimesR3, a  bank consortium working to create industry standards for using block chain technology in banking, has released a paper claiming efforts to modify public block chains to secure off-chain assets using colored coins and metacoins do not provide secure, legal settlement finality of those assets.

Titled “Watermarked Tokens and Pseudonymity on Public Block Chains,” the paper argues that a distributed public ledger that secures off-chain assets cannot be both legally authoritative and censorship-resistant. Written by R3 researcher Tim Swanson, the 78-page paper goes into a lot of detail on this very complex subject.

To achieve the goal of issuing, tracking and transferring virtual representations of off-chain assets, several startups have emerged to provide watermarking services, commonly referred to as “Blockchain 2.0,” the paper notes.

An ‘Impractical’ Solution

A ledger that doesn’t offer one-to-one correspondence between what the internally-derived network says and what externally-derived jurisprudence says about a financial contract’s status amounts to a network that can’t exist without the settlement framework it seeks to replace. The settlement framework will continue to remain the authoritative record of ownership.

“In practice, the censorship-resistant aspect of Blockchain 2.0 is impractical as a solution for financial settlements in cash, securities and other off-chain property titles,” the paper states.

Problems With Watermarking

The paper argues that it is shortsighted and ill-advised to attempt to secure off-chain assets using cryptocurrency-based platforms. It cites three reasons why financial organizations looking to use a public block chain should be skeptical of a watermark approach:

  1. The security system in proof-of-work-based block chains cannot be exported in a regulated financial settlement environment.
  2. The lack of legal settlement finality.
  3. The regulatory risks a watermark brings.

Recent marketing has highlighted a new functionality – watermarking – which extends the use of public block chains to include, beyond tracking ledger entries of specific on-chain assets (like bitcoin), the watermarking of a bitcoin to represent an off-chain asset.

Startups attempting to capitalize on the concept of watermarking assets have sought to allow users to take a fraction of a bitcoin and “color” it to represent a specific asset, such as the title to a certain vehicle or shares of a publicly-traded company. Theoretically, the private key holder can transfer the asset on a public block chain to other companies or individuals.

The paper notes two systems of watermarked tokens: colored coins and embedded consensus systems that use their own proprietary metacoins.

“It remains uncertain what the legal effect, if any, would be of Bob trying to transfer title of an off-chain titled asset vis-à-vis a public blockchain,” the paper states. It notes that no motor vehicle department or property system presently recognizes watermarked virtual tokens as proof of ownership.

Also read: Bankers begin using block chain technology without bitcoin

Off-Chain And On-Chain Environments Differ

The lack of recognizable identity between off-chain and on-chain environments presents an obstacle for financial institutions.

Despite efforts to enable public block chains to secure off-chain registered assets via colored coins and metacoins, these block chains, due to how they are designed, cannot provide secure, legal settlement finality of off-chain assets for regulated institutions that trade in global financial markets, Swanson wrote on Great Wall of Numbers, a website focused on business opportunities and challenges in emerging markets.

Institutions that trade financial products operate in an environment that has security assumptions and goals that differ from those of public block chains.

Swanson says this is a very important issue that has been glossed over despite millions of venture capital funding into companies attempting to (re)leverage public block chains. He said he hopes this paper will encourage more examination into the security of watermarking-related initiatives.

Images from Shutterstock and R3/Facebook.

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