Building Smart Property Applications: Colored Coins and Mastercoin

[Note: below is my recent article published on CoinDesk.]

Cryptoledgers such as those utilized in cryptocurrencies like Bitcoin and Litecoin have the ability to be employed in other capacities.  They are not merely one-dimensional, one-trick ponies relegated to simple fiat-only exchanges.

For example, last week Kyle Torpey published an overview of several upcoming projects that utilize the Bitcoin blockchain to provide new features and financial instruments for users globally.  While it is uncertain that any or all will be successful in accomplishing their goals, these new innovations, like Namecoin before it, show that cryptoledgers can be integrated to provide rich functionality beyond the current token system.

For those unfamiliar with Namecoin, it currently acts as a decentralized DNS system that makes domain name censorship difficult, if not impossible.  It was created in 2010 as a modified version of Bitcoin and in 2011 the mining of Namecoins (after block 19200) was effectively merged with Bitcoin through a software update (e.g. pools had to use a new software release).  While Namecoin provides DNS functionality it can also be utilized to be used as a messaging system, torrent tracker and even as a notary (which other cryptocurrencies can do as well).

The next release of Bitcoin currently being developed, version 0.9, will include a number of changes.  In the words of lead developer Gavin Andresen it includes the ability for “developers [to] associate up to 80 bytes of arbitrary data with their transactions by adding an extra “immediately prune-able” zero-valued output.”

What this allows for is a little more space in the output section to provide users the ability to add some new data (such as a distributed contract) to be included via a hash.

Why is this important?

In 2012, Mike Hearn (a Bitcoin developer now on the board of Circle) gave a presentation in London in which he describes other financial instruments and practical business uses that a cryptoledger can provide through the use of “timelock” (technically referred to as nLockTime).  This makes it possible to build ‘smart property’ or contracts that in turn create a distributed digital verification system that bypasses the need for a central repository.   A couple examples Mike gives are the transfer of goods (such as a car) and the execution of a trust fund (through a will), both of which can be conducted without many additional intermediaries.  For example, if a car ignition system is reengineered to connect with a cryptoledger protocol, it could enable car owners to buy and sell vehicles remotely via trusted timestamping.  The execution of a will (e.g. disbursement of a trust fund) is also possible, albeit slightly more complicated in that someone would need to build a system that can scan obituaries for deaths and notify the blockchain of any changes.  In actuality the potential applications can be expanded to anything that involves rights verification such as stocks, titles to houses, digital media as well as the keys to houses and cars.  In fact, this past fall Mike gave another interview describing these potential applications in more detail.

Coloring within the lines

Another potential way to utilize a crypto blockchain to verify wares is through a process being developed called Colored Coins.  In a nutshell this endeavor allows users to “color” a token to represent a specific asset such as a car, home, boat, commodity, shares, bonds – virtually any type of asset (e.g., 0.5 BTC colored green to represent your home).  These tokens can then be exchanged, just like bitcoin tokens, by anyone anywhere.  This enables a decentralized, trustless form of asset management that uses a blockchain as both a ledger and transportation mechanism.

I spoke with Alex Mizrahi, who is leading the development of the Chroma Wallet used by the Colored Coin project.   According to him, “It is going to be very easy for the asset management industry as a whole to use Colored Coins.  For example, some of the first places we are going to have adoption will likely be real-estate and portfolio management.  In fact, for any type of asset management it’s going to be simple to issue his own color that represents his goods.  A portfolio manager can issue one color that represents a portfolio of stocks backed by the real holding and sell it globally.  If he is savvy and his products are good, his colors are going to have demand.  So transferring ownership is very easy, quick and safe — just like bitcoins.  In the real estate industry someone can issue their apartments using colored coins and have them float on the blockchain, or manage time-sharing based on color.”

I also spoke with Amos Meiri, head of dealing at eToro and also a member of the development team for the Colored Coin project.  I specifically asked him if it would be easier to simply conduct all trade privately at the centralized exchange where it will be more scalable and private.  In his view, “Centralized exchanges definitely have their advantages, but colored coins can be useful for following reasons.  First, users do not need to trust their bitcoins to a centralized exchange.  Companies cannot manipulate ownership records (to commit fraud, for example).  So basically, if somebody gives you an IOU, it isn’t a good idea to leave it with the person who issued it or to affiliated parties.  Another reason is that companies cannot control how its shares are being traded, thus it cannot block trade.   And lastly, there is no need to maintain servers or manage security due to its integration with the blockchain.”

While this is obviously easier said than done, as noted above, this idea of using cryptoledgers to manage smart property has inspired and motivated numerous other groups to work on similar efforts.  For example, was recently launched this month.  Its mysterious, relatively anonymous development team has released similar open-source applications, documents, binaries and tools that allow users and entrepreneurs to build smart property functionality such as derivatives and dividends in a decentralized manner.  And three days ago, Jon Southurst discussed several other groups including Reality Keys which can utilize a crypto protocol to build a predictions market or a way to hedge against currency fluctuations.

Masters of the cryptoverse

This past week I spoke with Taariq Lewis, the founder and CEO of BitcoinBusiness, a Bitcoin Advisory firm and he is also the Smart Property and Business Development Lead of the Mastercoin Project.  Mastercoin is a crowdfunded, non-profit endeavor to create an open-source  distributed exchange protocol for Bitcoin.  The MC project has received more than $3 million in crowdfunding which has been used to pay for bounties, build tools and write documentation all of which is ultimately released open-source.

According to Taariq, “We are on the tip of the iceberg of the democratization of upper level finance and investment management.  One apt analogy is that the current system involves a highly siloed, highly centralized organization reminiscent to the music industry prior to P2P innovations.  We are now approaching the first wave of people being able to distribute financial products to each other on a peer-to-peer basis.  While this obviously has regulatory repercussions such as the SEC and CFTC oversight in the US, there is no ‘Wolf of Wall Street’ in crypto.  In fact, projects like Colored Coin, Counterparty and Mastercoin will create applications that will decentralize stock and bond exchanges allowing individuals and entrepreneurs to build dividend products and distribute the assets without middlemen.”

I also spoke with David Johnston, managing director of BitAngels and a board member at Mastercoin.  In his view, “Cryptocurrencies are more than a payment network, it is more than a new type currency or store of wealth.  It is a whole new platform and is a way for people to now make programmable money and that gives rise to smart contracts.  Now that this money is programmable I can put it into applications, I can create other digital tokens.  That’s what really gets me excited where anyone can build anything.”

The Mastercoin platform is still a work in progress and has gone through several iterations based on community feedback.  It also faces market competition from several others in this space such as Open-Transactions, Invictus (formerly BitShares) and potentially many others that learn of the potential business opportunities.   And as a consequence, it looks like a promising area for Christensen-style innovation.

Outside the dev world

For perspective I had an email exchange with Ryan Orr who is a professor at Stanford University (teaching Global Project Finance and Infrastructure Investment) and chairman at Zanbato.   He noted that, “with the recent wave of regulatory actions, I am personally feeling quite excited about how the “smart property” projects evolve in 2014.   It is starting to feel like smart property could be a much lower path of resistance for the bitcoin protocol as it establishes a “non-monetary” form of use that fulfills a valuable social purpose.  And thus it should not be viewed as a direct threat by regulators who are afraid of losing monopoly control of money. It is the “duality” of purpose of gold, where people can hold it under the auspices of non-monetary purposes, but also hold it for monetary purposes (eg. a hedge against inflation), that makes it so difficult for the governments to totally eliminate it as a form of money (even though the US government did try to do so in 20th Century).  If bitcoin can develop a similar duality, where the ‘smart property’ use makes it legitimate, and then people also can secretly hold it as an uncorrelated hedge against government dysfunction, then that could be pretty interesting.  In sum, it feels like the ‘smart property’ could become the ‘formal, legal, legitimate’ face to the project that can develop independent of how the regulators rule on the use of Bitcoin for monetary purposes.”

In addition, I also spoke with Ben Davenport, an angel investor and a member of the monetization team at Instagram.  While he does not necessarily endorse one specific project, in his view, “colored coin technology allows such centralized assets to be traded in a completely decentralized way.  Every single equity in the world has a central issuer — the company itself. But imagine the power of being able to make a trustless trade of stock for bitcoin with a stranger, at a distance, with no third party involved. With colored coins, I can construct a single atomic transaction which encodes such an exchange. That, to me, is the most important basic thing that colored coins can enable.”

The disruptive potential of smart property for the entire financial industry, not just fiat credit facilities, is enormous.  Charles Stross, the British Scifi author, recently criticized Bitcoin and the cryptocurrency endeavor, wishing that it die a quick death (in fire no less).  While his contentions were fallacious on a number of counts (especially regarding the environmental impact), ironically, he previously predicted seven years ago that near-future scifi authors are still probably missing something disruptively as large as the Internet 20 years ago or the smartphone was this past decade.

In other words, just as rewatching older scifi films that failed to foresee drones and self-driving automobiles seems dated, the portrayal of centrally managed financial products may one day be viewed as an anachronism of our not-so-quaint analog past.  Thus, Stross’ prediction of another unforeseen invention could very well be these smart property applications and digital financial instruments that are managed and transported by the very same cryptoledgers he dreamt of burning.

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