Table of Contents:

NFT and Crypto: Colored Coins

What Are Colored Coins and How Do They Work?

What Is the Origin of Colored Coins?

How Colored Coins Work

How Do Colored Coins Expand the Potential of the Blockchain?

Colored Coins and NFTs

What Is the Future of Colored Coins?

NFT and Crypto: Colored Coins

The NFT market is booming. According to blockchain analytics firm, Chainalysis Inc., more than $40 billion worth of cryptocurrency was sent to Ethereum smart contracts within the NFT space in 2021. With the market showing no signs of slowing down in 2022, there’s never been a better time to learn about NFTs and crypto.

Colored coins, a concept first conceived of by eToro CEO Yoni Assia, were a forerunner to NFTs. To understand where NFTs are going, you need to know where they came from, so as part of our educational series on NFTs and crypto, we’re taking you back to the beginning. This article explains what colored coins are and why they are still important in today’s crypto space.

What are colored coins and how do they work?

A colored coin is a cryptoasset that has been encoded with distinct information to distinguish it from other assets and identify it with a real-world asset or purchase.

The concept of “coloring” cryptoassets in order to tokenise real-world assets has become popular due to the rise of NFTs. However, to truly understand the NFT boom, you need to know what colored coins are and how they work. This guide explains how eToro CEO Yoni Assia came up with the concept of a colored coin and why these tokens can change the way we define ownership.

What is the origin of colored coins?

The term “colored coin” was created by eToro CEO, Yoni Assia, who co-authored a 2013 whitepaper called Colored Coins with Ethereum creator Vitalik Buterin. In it, Assia and Buterin described the need to update the Bitcoin blockchain so that metadata could be added and, therefore, processed.

Assia and Buterin proposed that it’s possible to “color” a set of Bitcoins to distinguish them from the rest. The Bitcoin blockchain would, therefore, be split into two layers:

  • The fundamental layer, which processes transactions using cryptographic technology
  • An overlay (aka open asset), where colored coins could be processed

Creating an overlay meant that colored coins wouldn’t alter the source code of Bitcoin. However, the transactions could be processed on the blockchain. Assia and Buterin saw this process of coloring coins as a way of facilitating non-monetary transactions.

To put it another way, colored Bitcoin coins can be used to signify ownership and transference of things other than money, such as shares in a company, tokens in a game, or contracts.

How colored coins work

Within the term “colored coin,” the word “color” is being used to describe the process of making something distinct. An identifiable distinct element is coded into the metadata of a coin, and that’s what makes it colored.

Colored coins are…

A colored coin is a cryptoasset that’s been repurposed to represent something of value by adding extra information to it, called metadata.

Now that we have explained what colored coins are, to provide some additional context and explain how colored coins crypto transactions work, below is a brief overview of how coloring happens.

Step 1: the genesis transaction

A genesis block must be generated to release the colored coins. Therefore, after the metadata has been created, it’s added to the first (original) block in a chain. This is the genesis block, and the initial transaction is known as the genesis transaction. This sets the rules for all future transactions.

One technical point to note is that a new output has to be created to ensure that the extra data from a colored coin doesn’t slow down the network. For Bitcoin, the OP_RETURN data output is followed by one or two change outputs. The OP_RETURN output may be 40 bytes of data. Therefore, all of the metadata defining a colored coin can’t be over 40 bytes. This allows colored coins to remain as standard transactions and not disrupt the network as a whole.

Step 2: transfer transaction

Once blockchain colored coins have been created, they need to be sent. This is where a transfer transaction comes in. Basically, you need the ability to send a colored coin from one colored coin wallet to another. Both addresses must recognise the coin, so the input and output data need to sync up. This is where coloring algorithms come into play.

Step 3: coloring algorithms

Coloring algorithms are the mechanisms that allow transactions to take place according to a set of predefined rules. There are a variety of different coloring algorithms, including:

  • BC (Order-based Coloring)
  • TBC (Tagging-based Coloring)
  • POBC (Padded Order-based Coloring)

All are slightly different, but define the same fundamental rules.

These mechanisms provide structure to the transactions and tell the sender and receiver of the color coin wallet the following things:

  • The color balance of the network (i.e., all inputs)
  • The position of the outputs (i.e., the coins in the transaction) relative to the inputs
  • The size of the outputs in relation to the network
  • The details of the script and code (i.e., data) of the outputs

The coloring algorithms ensure that every transaction complies with the rules. This allows colored coin transactions to happen smoothly, securely and without a central point of control. What’s more, the algorithms ensure colored coins are non-fungible, so they can’t be changed.

How do colored coins expand the potential of the blockchain?

Blockchain colored coins make it possible to send something other than money in a decentralised way. Although Bitcoin was the original focus for colored coins, other blockchains have adopted the concept in recent years. The most prominent example is Ethereum. Colored Ethereum tokens can be used to signify real-world assets such as proof that you own a property or virtual tokens in a game.

In turn, the holder of said coins has irrefutable proof that they own the asset. For those interested in NFTs, you can see how colored coins have formed the basis of non-fungible tokens.

Before we look at the colored coins vs NFTs debate, below are some potential uses of the colored coins.

Smart property

Colored coins have the ability to authorise the use of smart property. Assia theorised that a rental company could assign colored coins to cars. Each coin could only be activated by a unique private key, and this key could be contained within a message sent to the renter’s smartphone. The key would send a signal from the phone to the car and unlock it, thus, creating a situation where only the person renting the car could use it.

Company shares, contracts and bonds

A company could issue shares as colored coins. This would not only allow them to be traded, but show irrefutable proof of ownership. You can do the same with contracts and bonds.

Demand deposits

Colored coins could be used to represent deposits. People could trade Bitcoin colored coins or Litecoin tokens and have a record of their deposit.

Emergent currencies

A new currency could emerge from colored coins. The coin could exist on the Bitcoin blockchain, but have a separate value and characteristics than BTC.

Colored coins and NFTs

Non-fungible tokens (NFTs) emerged from the concept of colored coins. The colored coins vs NFT debate can be complex and nuanced, but there are a few basic points that can help provide some background on the subject. The concept of adding non-fungible assets to a blockchain originated in Yoni and Buterin’s 2013 paper. The idea that you can add an overlay (open asset) to a blockchain to create a subset of unchangeable tokens is the theory behind colored coins.

NFTs are an evolution of this concept. Following the 2013 whitepaper, Robert Dermody, Adam Krellenstein and Evan Wagner founded Counterparty in 2014. This decentralised exchange allowed users to create, send and receive their own colored tokens. By 2016, digital trading cards based on colored coin technology were being traded on Counterparty. This trend eventually evolved into memes such as Rare Pepes.

The release of the CryptoPunks in 2017 brought the popularity of NFTs to a new level, and it was arguably the point at which the Ethereum tokens started to overtake those on the Bitcoin blockchain. Developed by Larva Labs, these 10,000 digital characters were all unique and what many would describe as the first modern NFTs. They were based on the same concept as colored coins, which meant they were non-fungible assets within the Ethereum blockchain. Specifically, they were a special type of ERC-20 token.

Today, the colored coins vs NFT debate is one that many in the mainstream don’t appreciate, but the basics are simple enough to grasp. Non-fungible tokens are being used to represent digital artwork, i.e., a non-monetary asset. This is what colored coins were designed to represent. Thus, both colored coins and NFTs can represent real-world assets. The holder of an NFT is recognised as the owner of said asset, something that everyone can verify thanks to the blockchain.

What is the future of colored coins?

The concept of colored coins made it possible to trade bitcoins as something else. However, Bitcoin’s early proof of work method for processing transactions has been superseded by proof of stake, which is used by blockchains such as Ethereum.

This evolution has led to the decline of colored coins, mainly due to Bitcoin’s slower transaction speeds. This is why NFTs have taken over blockchains such as Ethereum. However, were it not for colored coins, the NFT boom might not have happened. What’s more, there are still several benefits to colored coins.

Pros

  • You can tokenise multiple assets;
  • They are backed up by the most used and secured blockchain of all (the Bitcoin network);
  • There is the possibility of creating an unlimited number of coins that don’t require their own network or dedicated hardware;
  • They extend the use of decentralised exchanges.

Cons

  • Highly complex to implement and develop;
  • Possible high risk (e.g., representing securities).

There is still a case to be made for colored coins. With Bitcoin 2.0 creating a more efficient way of processing BTC transactions, there may be a resurgence in colored coin usage. Regardless, the original Colored Coins whitepaper by Yoni and Buterin has changed the game and made the tokenisation of real-world assets possible.

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