The colored coin protocol enables any issuer to use a Satoshi (1 millionth of Bitcoin) as a vehicle for an IOU. The issuer specifies the terms and conditions of the IOU, which can be virtually anything.
Bank AAA, for example, can specify the following: The holder of this colored coin is entitled to receive 1 million USD upon redemption.
If Katherine has a bank account with Bank AAA, she can request that her assets in the amount of 1 million USD be converted into the bank’s colored coin, worth 1 million USD. She can then use the bank’s colored coin to buy and sell other colored coins from this bank, or from any other bank, or from any other issuer, for that matter.
Settlement with the real world is straightforward: Katherine simply converts her colored coins into a regular balance of USD in her account at Bank AAA.
It is obvious that such a system only works well if the marketplace offers efficient price discovery. Lykke plans to implement a new type of matching engine (price, time, and spread queuing), which is more efficient than the traditional approach (only price and time queuing) in preventing price spikes.
See the Price-Spread-Time priority White Paper.