R3's Tim Swanson examines 'watermarked tokens' on the Bitcoin blockchain

The R3 project has issued a report criticising "watermarked tokens" such as coloured coins and other meta-data solutions which try to attach digital assets to the Bitcoin blockchain.

The report, "Watermarked tokens and pseudonymity on public blockchains" by Tim Swanson, is deeply researched and wide-ranging, swooping on areas like security and regulatory compliance, and highlighting tensions within Bitcoin's censorship-resistant model.

For example, turning a bearer asset into a registered asset as explored by Nasdaq and others is nullifying the primary utility of Bitcoin: censorship-resistance. However, the high marginal costs to maintain the underlying public network still remain, argues the report, delivering the worst of both worlds.

The report goes on to mention the regulatory requirements of issuing, tracking and transferring virtual representations of off-chain assets. The idea of complying with KYC and AML also clashes with being pseudonymous.

Swanson, head of market research at R3, states in the report: "Many startups that raise outside funding from venture capital empirically have attempted to become more compliant with existing laws and regulations. But in doing so, by establishing mandatory KYC and AML documentation, it runs counter to the original utility propositions of these pseudonymous systems."

At the outset he says: "This paper will show that a public, distributed ledger (such as Bitcoin) that secures off-chain assets cannot be both censorship-resistant and legally authoritative.

"Consequently, a ledger that does not provide a one-to-one correspondence between what the endogenous network says and what the exogenous jurisprudence says about the status of a financial contract is a network that cannot exist without the legacy settlement framework that it seeks to replace, for the latter 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."

Developers within the coloured coin community and its descendants, pointed out the technology is still evolving and that security and regulatory compliance are priorities.

Flavien Charlon, CEO of Coinprism and the creator of OpenAssets and OpenChain, told IBtimes in an email: "Going back to the early days of Blockchain technology (late 2013, 2014), the first few projects in the space, such as coloured coins, Counterparty and a few others, were exploring the concept of watermarking.

"Coinprism actually pioneered the first implementation of coloured coins (Open Assets). Open Assets slowly gained traction over the course of 2014, up until the point where NASDAQ announced they were experimenting with Open Assets.

"As the interest for Blockchain technology in the finance sector grew, and as we started to talk to a number of financial institutions and corporations about their use cases for Blockchain technology, we realised that watermarking systems were often not a good fit for what they were trying to do.

"This is why we started to build Openchain early 2015. Openchain solves the same problems as watermarking protocols, but with a much lighter use of the Bitcoin Blockchain. This way we can achieve a much higher scale, and handle compliance in a much better way.

"I don't think Coinprism and R3 are the only two companies in the space to have realised this. There has been a noticeable turning point in the industry around mid-2015, and more companies are now building permissioned ledgers."

Another coloured coin developer ChromaWay also responded and turned the tables on security concerns for permissioned ledger systems, which R3 is currently corralling banks toward.

Henrik Hjelte, CEO ChromaWay told IBTimes: "We also need to have more security research directed to the permissioned systems that is put forward as alternatives. Permissioned systems are not immune to attacks and history shows that banks and bank-employees have sometimes acted in bad faith.

"ChromaWay have been focusing on security since Alex Mizrahi came up with coloured-coins back in 2012 and we are taking the same security focused approach to our brand new inventions and offerings to financial institutions."

Amos Meiri, founder of Colu was slightly more caustic in his response. He told IBTimes: "The Colored coins and the Bitcoin protocol are not finalised, and continue to evolve and change. Attacking a complex technology in its early stages and nullifying it by referencing papers that were written years ago is not relevant. Especially when a better alternative is not displayed and the same paper could be written on R3 initiative and private blockchains in general.

"Coloured Coins was a hack like how most technology started. You can't put all the 'meta' solutions under the same umbrella. At Colu we released a new protocol that solves some of the technical issues in the paper and we keep improve the technology every day.

"Any technology that is censorship resistant and decentralised will be criticised from a financial institution perspective, the biggest questions is not whether the technical problem are solvable but do financial institutions want them to be solved.

"There is no 'good' approach or 'bad' approach for this technology - the truth is always somewhere in the middle. As long as we are keeping the basic principles of this technology (open source and decentralised) you can always improve the Bitcoin/CC implementation and create specific solutions for specific use case, for some use cases a distributed network is better and for some not - i am against generalisation of this complex technology.

"This research blatantly disregards the fact that few dozen Bitcoin companies are using OP_RETURN today and the volume of transactions is steadily rising. It also doesn't mention the fact that a lot of companies that are working on solutions for financial institution are basing their design on Bitcoin for possible future interoperability - this might solve a lot of issues mentioned in the paper."