The value of a decentralized exchange is only realized when those entities offering "cash-out" start to honor it as a trusted source for prices. Once entities allow for the crypto units in the exchange to be changed for real units, based on the trust that these crypt-units in the exchange network will always be exchangable for spendable units at the prices tracked in the decentralized exchange, a decentralized exchange can become a reality. The first stage of launching a decentralized exchange, is to bootstrap it with a centralized exchange that allows cash-out in colored units on the decentralized exchange. Once the decentralized exchange is being used as a "price-finding" mechanism by all entities that allow cash-out (the same way Mt. Gox is used now by people on LocalBitcoins), the decentralized exchange gains legitimacy and the prices tracked on that exchange gain real-world values.
In the parent post of this thread, it was decided that colored-coins are not an option, because they would have to be backed by a "central" authority who could be trusted as a source to redeem the backed currency, but this is not necessarily the case. Under the following model, the colored coins could be redeemed anywhere that places trust in the following:
1. the value of the underlying currency (such as bitcoin, if that were used)
2. the prices determined for the colored coins by the decentralized exchange.
As I explained above, once enough places rely on the decentralized exchange as a price finding mechanism for cash-out, the above 2 conditions are fulfilled, because the very fact that you can cash-out a colored coin for its equivalent in real-coins forces the colored coins to maintain parity with the real thing.
Now, the problem faced with coloring bitcoins is that they must be colored by an authority... but who is an authority for USD? Certainly, the government is not going start backing a colored version of the US dollar...
So I propose the following system (alt-coin) to opperate as a decentralized exchange and to allow anyone to "color" the base currency:
(Note: This could potentially be built on top of BitCoin, but is unlikely to ever happen)
This is an extension to my previous idea of "BaseCoin" (
https://bitcointalksearch.org/topic/method-for-decentralized-crypto-exchange-not-ripple-208009 ), but with a retraction of the idea to "track the blockchains of alternate crypto-currencies", and an introduction of colored coins for the purpose of exchange instead, but with the ability for these colored coins to be minted by anyone on the network, and to be redeemable (ie. destroyed and replaced with underlying currency at current market rate). Also, it extends the initial idea with the ability to transact directly (send colored coin from one address to another) in addition to being able to transact by submitting offers, which implicitly cause currency to be exchanged between addresses.
Here is the extension to the proposal:
Changes to basecoin concept:
* Network no longer attempts to track blockchain of alternate coins.
* Colored coins can be created from basecoins, but this is not done by assigning color to an existing coin. Instead:
1. A request to mint some currency is made by submitting a special
transaction that destroys the basecoins and releases colored coins at
"market-rate" in the currency of choice (ie. they go to the bid that is
closest to the previous successful trade price for that color of coin). If
there are no bids currently on the network, then they go to the first bid.
2. The amount of colored coins released is determined by the bid (ie. 2
basecoin/US dollar)
3. The basecoins used to buy the colored coins are sent back to the address
that the basecoins were sent from to be minted. Note: no new money was
created. The original minter gets the exact amount of basecoins back that he
used to mint with from the buyer of the colored coins.
4. At any point, any colored coins on the network can be converted back to
basecoin. If the market value for those coins has gone up, more basecoins are
in fact created by that transaction than it originally took to mint the
colored coins. If the value of colored coin relative to basecoin has gone
down, then fewer basecoins are introduced back into the network. So quantity of basecoin in circulation can potentially fluctuate.
5. This process allows the participants in the network to control the amount of each currency available for trade.
* Colored basecoins can be explictly sent from address to address without submiting an offer to the network.
Notes:
* Basecoins can not be purchased directly (they cannot be sent from one address to another they can only be used to submit offers) in order to enforce use of the exchange as a method of price-finding, otherwise, people would exchange cash for basecoin and the network would be incapable of tracking the price that those basecoins were sold for.
* Basecoin is a mined currency. I would not place a limit on the amount of
basecoins that can be mined; I think mining difficulty does a perfect job of
limiting inflation of basecoin value.
* In order to obtain basecoins, one must first purchase colored basecoins in currency of choice, and then trade for basecoins on the basecoin network by submitting an offer. (Or mine them of course)
* In order to exchange one currency for another: carred-currecy -> colored basecoin -> basecoin -> colored basecoin -> cash-out.
* This decentralized network only works as long as there are many places that are willing to use it for price discovery and to accept colored coin in exchange for the represented currency. If a coin is colored "USD", it only maintains the value of real USD due to many places willing to allow cash out. These places would then sell those colored USD to others who wish to make use of the network.
* Transaction fees can be applied to trades between basecoin and colored coin, just as they are applied to sending coins from one address to another in order to encourage miners to include these trades in the blockchain.