Beginner’s Guide: What Are Colored Coins?
What Are Colored Coins?
Since Bitcoin’s original design was aimed towards being a currency, it features a limited scripting language for storing metadata on the blockchain. Colored Coins are an advanced application of Bitcoin’s blockchain which allows attaching metadata to Bitcoin transactions. The protocol expands the use of the coin’s blockchain, making it having Bitcoin 2.0 properties.
To put it into simpler terms, Colored Coins are tokens which represent real-world assets. They can be issued to take the place of stocks, real estate, bonds, commodities, fiat currencies, precious metals, and even other cryptos. They can also be used to store information, such as documents or certificates, and also for the issuing of smart contracts.
While there are currently not many cryptos which can be considered Colored Coins, the few ones pose some interesting features. Colored Coins are commonly used by companies that want to host an IPO. The advantage of launching an IPO with Colored Coins is that it takes a few minutes and it comes at a low cost. ChromaWallet is a wallet which let companies create and issue their shares by using colored coins, which can then be freely exchanged on the Bitcoin blockchain almost immediately on a global scale, with very low costs.
Another advantage given by the use of blockchain in issuing these assets is that it provides transparency, immutability, ease of transfer, and the trade of such digital tokens cannot be counterfeited, allowing for a secure and easy transaction.
Each satoshi – the smallest part of a Bitcoin that can be transferred, can be regarded as billions of identical empty sheets of paper. All of these sheets are generated by the Bitcoin network for its verification process.
Before a change in the coin’s programming language was made on April 19, 2014, you could not add or “write” new information on the papers because that would have led to Bitcoin’s destruction. This is because the network would no longer be able to spot the files that were “corrupted”. To bypass this, users started adding data to transactions which included messages or other information.
The community thought that this weighed down the blockchain, so a function was implemented which enables users to add information to a Bitcoin without compromising its spending ability. This is how colored coins came to existence, and now, various types of value can be attributed to them, allowing them to be transferred while simultaneously maintaining the ownership of coin and the asset tied to it.
The Colored Coins Protocol
On Github, there is posted the document which describes the Colored Coins protocol and its specifications for issuing and transacting with digitized assets on bitcoin’s blockchain.
This Document is comprised of two main parts:
1. The Coloring Scheme
The coloring scheme defines the code used for the encoding/decoding of the data which is stored in a bitcoin transaction of a Colored Coin after the OP_RETURN operator (and occasionally in one supplementary multisignature output). This coloring scheme is to enhance the functionality by introducing the most data within the current size restrictions of the OP_RETURN operator (80 Bytes).
2. Asset Metadata and the Rule engine
This document presents the first specification regarding how metadata should be handled with digital assets. Due to the 80 Bytes limit of the OP_RETURN field, any metadata which is added to a transaction is hashed and stored in torrents to enable the decentralized access of the stored data.
Through the metadata hashing of each transaction, Colored Coins can exponentially expand the basic Bitcoin functionality by enabling the insertion of rules from outside the blockchain, the public access via torrents and the verification against a precise transaction, therefore, generating a rule mechanism with basic smart contract applications.
The Advantages of Colored Coins
The most important advantage that colored coin have is that it runs on the BTC blockchain and is therefore secured by the enormous hardware and hashrate power which back up the network. You can issue an unlimited number of coins that don’t require to have their own network or dedicated hardware, all of them receiving support from the network.
In the future, colored coins might take the place of many expensive and time consuming financial transactions.
The Disadvantages of Colored Coins
As colored coins represent real-world assets they have financial implications. Because of this, they have to be issued by a certain entity, which poses a risk. The issuer might decide not to go through with his end of the deal and honor the value established for the coin. There could also be the risk the that the colored coin will not meet represent anything at all.
But one of the biggest disadvantages of these coins is the lack of wallets that can support them. They also have to face a powerful competitor- Ethereum- as its ERC-20 tokens are the go-to tokens for issuing new coins and ICOs.
Even though colored coins are not something novel as they have been around for years, they need more maturation, as in their current state they cannot compete with the Ethereum blockchain.