Watermarked tokens and pseudonymity on public blockchains
By Tim Swanson Published: November 4, 2015 Abstract Over its nearly seven-year incubation, Bitcoin has attracted a diverse set of entrepreneurs, developers, investors and researchers. While the initial attraction revolved around the recreation of a pseudonymous bearer asset, over the past year there has been a steadfast attempt to enable the Bitcoin network to transfer and secure off-chain registered assets. To achieve the goal of issuing, tracking and transferring virtual representations of off-chain assets, several startups have begun to provide watermarking services, commonly referred to as “Blockchain 2.0.” 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 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.
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Table of Contents
Abstract ..................................................................................................................................................... 1 Section 1: Background on the term
watermarked tokens
 ........................................................................ 3 Section 2: Registered assets conflict with Bitcoin’s security assumptions ............................................... 7 Section 2.1: How ungated overhead may lead to a “Top Heavy” scenario ............................................ 11 Section 2.2: Turning it to eleven ............................................................................................................. 17 Section 2.3: What is merged mining and why it is considered important .............................................. 19
 
Section 3: Traceability and permissionlessness ...................................................................................... 23 Section 3.1: Government sanctions ........................................................................................................ 27 Section 3.2: Encumbered titles ............................................................................................................... 34 Section 3.3: Uniform Commercial Code .................................................................................................. 36 Section 3.4: FinCEN impact on watermarked tokens ............................................................................. 38 Section 3.5: The Securities and Exchange Commission .......................................................................... 40 Section 4: Conclusion .............................................................................................................................. 42 Acknowledgements ................................................................................................................................. 44 Disclaimer................................................................................................................................................ 45 Appendix A: Internal governance ........................................................................................................... 45 Appendix B: A straw man game theory model ....................................................................................... 54 Endnotes ................................................................................................................................................. 60
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Section 1: Background on the term
watermarked tokens
 This paper is meant to provide readers a general overview of what watermarked tokens are, and what challenges exist for financial institutions looking to utilize these tokens on public blockchains. Specifically, it presents the argument that it is shortsighted and ill advised to try to secure off-chain assets with Bitcoin or other public cryptocurrency-based platforms. There are at least three identifiable reasons that financial organizations looking to use some kind of public blockchain should be wary of a watermarked approach: 1)
 
the built-in security system inherited from Bitcoin and other proof-of-work-based blockchains is not exportable in a regulated financial settlement setting (through a distortion of incentives);
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 2)
 
the lack of legal settlement finality; and 3)
 
the regulatory risks that a watermarked approach introduces (see details in section 3) This paper prefers to use the term
watermarked
token to encompass two types of systems: 1)
 
Colored coins and 2)
 
Embedded consensus systems which use their own proprietary metacoin The current industry typically conflates colored coins for metacoins (and vice-versa) but they are technically not the same. Therefore, the term “watermarked” could be seen as a more inclusive umbrella term at this time. Over the past two years, considerable marketing and advertising has attempted to highlight new functionality in the form of ‘watermarking’ which promises to expand the extensibility of public blockchains such as Bitcoin. The end goal is to enable Bitcoin (the network) to go beyond tracking ledger entries of just one specific on-chain asset (e.g., a bitcoin) to also allow users to watermark a bitcoin (sometimes referred to as a “token”) to purportedly represent a sundry of off-chain assets.
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 While the term “token” has a number of distinct definitions, for the purposes of this paper a
token
 is limited to a discrete amount of unspent transaction outputs (UTXOs) that is tracked on a distributed ledger (which in this case is a blockchain).
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 These watermarked tokens act as representations for assets (e.g., common stock, gold, car deeds) that are exogenous to the ledger itself. Or in short, a watermarked token in this manuscript is a discrete amount of bitcoin that is tracked on the Bitcoin blockchain and is supposed to represent external value. For instance, according to the first whitepaper on colored coins by (Rosenfeld 2012), these watermarked bitcoins can purportedly represent “alternative currencies, commodity certificates, smart property, and other financial instruments such as stocks and bonds.”
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 Some literature (Schroeder 2015) refers to these types of instruments collectively as “cryptosecurities.”
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