Unlocking the potential of the Blockchain: Managing counter-party risk with colored coins

The global economy is a complex system where financial markets function to disseminate signals. From our everyday experience with similar systems—such as the human body—we are aware that minor deficiencies can have a disproportionate impact. While the conventions of financial markets may appear to be petty details of execution and therefore irrelevant to global welfare, in actual fact, the subtleties of financial architecture carry a substantial macroeconomic impact.

Today's global economy is based on instant communication, but the financial system, which transacts trillions of dollars on a daily basis, still follows business procedures from a time when there was no help from modern computers, when physical pieces of paper had to be moved and verified. This explains why, even today, international payments take two business days, which is quite extraordinary in our age of instantaneous communication. This archaic payment system has a hidden but significant impact on financial market stability.

The Blockchain is a genius invention that has the potential to completely re-engineer the financial system. Just recently, the Bank of England and the Federal Reserve System of the United States were the first central banks to state that the innovation of the Blockchain is the most important discovery since the introduction of double-entry bookkeeping. The Blockchain is a global distributed ledger that allows for immediate settlement of financial transactions: When a transaction occurs, it is broadcasted to the so-called ''miners'' of Bitcoins, who verify it and, within minutes, update the global ledger with the completed transactions and asset ownership.

In addition to immediate settlement, the Blockchain also allows for every financial asset to be a listed security in the form of a colored coin. The issuer of colored coins takes a fraction of a Bitcoin and specifies the financial asset that it represents, guaranteeing to hand out the underlying assets to whomever redeems the colored coin. For example, the Federal Reserve could issue a colored coin representing U.S. dollars simply by designating it as such; the colored coin acts much like an IOU. This protocol can be used for any financial claim by specifying the asset's International Securities Identification Number, or ISIN, which makes transactions, bookkeeping, and risk management of colored coins straightforward for traditional financial institutions.

Immediate settlement and the colored coin protocol of the Blockchain represent significant advantages for participants in financial markets. Counter-party risk can now be transferred from one issuer of a colored coin to another, at a moment’s notice. This is a seminal change that will reinvent the management of counter-party risk: If an investor holds a colored coin representing a deposit of U.S. dollars issued by Goldman Sachs, the investor can sell that colored coin and buy another representing a U.S. dollar deposit issued by Deutsche Bank at any time. Within minutes, the investor moves counter-party risk from Goldman Sachs to Deutsche Bank. There does not yet exist any other marketplace that offers a similar feature. Investors cannot move funds instantaneously, so they are hostage to a particular counter-party for two or more days.

In addition to counter-party risk, investors also incur settlement risk, because they have to wait out the two days’ settlement just to change the counter-party. The fallout of the Lehman Brothers crisis highlights the risks of delayed settlement. We anticipate that colored coins will better align interest among financial institutions, governments, regulators, investors, and the general public, since the value of colored coins will depend on the issuer's reputation, providing a built-in correction mechanism for the behavior of financial institutions. If the issuer does not behave in a socially responsible manner, the market value of that issuer’s colored coins will immediately plummet.

The vested interests of the current, unsustainable system cannot stand in the way of the social benefits that accrue from immediate settlement and the colored coin protocol of the Blockchain. These benefits include more stable financial markets, the disappearance of misalignment interest, lower volatility with improved economic growth, and the reduction of systemic risk.

Lykke Corp is building a global marketplace atop the Blockchain for all assets and instruments. Our marketplace will use distributed ledger technology and colored coin protocol to offer immediate settlement and direct ownership. Distributed ledger technology offers a unique opportunity to rewire the existing financial system and create a highly efficient one. We are committed to sharing our knowledge, and we invite everyone to join our endeavours. All our software is open source. Our goal is to build the most efficient marketplace possible.