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What Are Colored Coins and How Do They Relate to Bitcoin?

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Some of the biggest developments on the Bitcoin network over the years utilize one innovation: colored coins.

While colored coins never really took off, they did drive a number of applications and protocols whose adoption is significant for Bitcoin today, including NFTs and the tokenization of digital assets. Many believe that the colored coin protocol, which was built on top of the Bitcoin blockchain, is still a key aspect of Bitcoin 2.0 and has given sound examples of different ways that people can take advantage of the Bitcoin infrastructure. As a result, they also believe that colored coins have encouraged the Bitcoin community to find additional use cases for the world's oldest blockchain that can scale and rival even the likes of Ethereum.

Although colored coins have lost much of their popularity over the last few years, the recent RGB protocol has put colored Bitcoins back in the spotlight. While any crypto blockchain can, technically, create colored coins and use colored coins, the protocol has always largely found its place in the Bitcoin community.

A History of Colored Coins

The first mention of the concept of colored coins and colored coin transactions was actually in a blog post authored by Yoni Assia, the founder and CEO of eToro. The post, titled "bitcoin 2.X (aka Colored Bitcoin) - initial specs," proposed the idea of using a Genesis transaction to create a new cryptocurrency that uses a certain amount of bitcoin. These "ordinary bitcoins," as he described, would turn into "colored bitcoins" upon being transferred in the Genesis transaction. 

Just a few months later, many of the concepts mentioned by Assia were expanded upon by Meni Rosenfeld in his "Overview of Colored Coins" white paper published in December 2012. Rosenfeld, who is the current chairman of the Israeli Bitcoin Association, suggested that a small amount of bitcoin could be "colored" to represent another asset or commodity, such as a stock or a bond. This would allow for the tokenization of real-world assets on the blockchain, which would enable easier trading and transfer of ownership.

A year later, Assia, Rosenfeld, and Ethereum founder Vitalik Buterin were among the authors of the "Colored Coins whitepaper" that more thoroughly laid out how a Genesis transaction's inputs and outputs led to the creation and transfer of new colorized coins, and the different use cases that colored coins allow for. It also significantly laid out how the OP_RETURN opcode, which was designed to allow the inclusion of arbitrary data in a Bitcoin transaction's output, would enable metadata to define colored coins.

Notable projects and protocols featuring the use of colored coins

But naturally, developers had already begun working on colored coin projects that explored the potential of colored coins using Bitcoin's blockchain capabilities. One of the earliest examples of this was the ColoredCoins project, which was launched in 2013. ColoredCoins used a custom software layer on top of Bitcoin to implement the colored coin functionality. That same year, Flavien Charlon -- who would later found Coinprism, a colored coins wallet -- proposed the Open Assets Protocol that used the Bitcoin blockchain itself to implement colored coin functionality, as opposed to relying on custom software.

In addition to Charlon's protocol, a blockchain company called ChromaWay introduced Enhanced Padded Order-Based Coloring (EPOBC), the first Colored Coins implementation in 2014. The protocol presented fewer limitations on inputs and outputs and transaction tagging, which would allow users to differentiate between uncolored coins, new colored coins that are part of Genesis transactions, and transfer transactions.

Among the most notable projects launched around that time was the Counterparty protocol in 2014, which enabled the creation of custom tokens on top of the Bitcoin blockchain. Counterparty was the first platform to introduce smart contract functionality to the colored coin ecosystem, allowing for more complex and customizable tokens to be created. Over the years, Counterparty would become a huge platform that drove awareness about colored coins through their association with virtual trading cards, including Spells of Genesis and Rare Pepes (which served as a prototype for what would later become known as NFTs).

Around the same time, other projects such as ChromaWallet and CoinPrism were also launched, each with their own unique approach to implementing colored coins. These projects allowed for the creation of tokens that represented various assets, from digital art to real estate, and they served as color-aware wallets that were used to send colored coins, as well as receive and manage assets. This was similar to how cryptocurrencies in general had been managed.

In 2015, the Omni Layer protocol was launched, which also used the Bitcoin blockchain to implement colored coins. Omni Layer expanded on the Open Assets Protocol by adding additional features, such as the ability to create sub-assets and to trade assets directly on the blockchain. During this time, new implementations that made use of colored coins on the blockchain included the likes of Coinspark and Colu.

How Do Colored Coins Work?

Colored coins work by designating a certain amount of Bitcoin as representing a specific asset or commodity. This is done by "coloring" the bitcoin, meaning that a unique identifier or metadata is added to the Bitcoin transaction to indicate that it represents a specific asset. Once the Bitcoin has been colored, it is known as a colored coin, which can be traded and tracked on the blockchain just like any other cryptocurrency.

The process of coloring Bitcoin can be done in various ways, depending on the implementation used. One common method is to use a custom software layer on top of the Bitcoin blockchain, which allows users to create and manage colored coins. This software layer will typically include a user interface that allows users to specify the asset they wish to represent and the amount of Bitcoin they want to color. Once the transaction has been processed, the colored coin is created and can be traded on the blockchain.

Another method of coloring Bitcoin is to use a protocol-based approach, where the Bitcoin blockchain itself is used to implement the colored coin functionality. As we mentioned in our recounting of the history of colored coins, there have primarily been two protocols used in this process: Open Assets and EPOBC. Open Assets colors coins by adding metadata to the OP_RETURN field in Bitcoin transactions, which allows for the creation of custom tokens that represent specific assets. EPOBC, however, isn't based on OP_RETURN, though its own creators acknowledge that in the case where larger atomic units are needed, the Open Assets protocol would be preferable.

Once colored coins have been created, they can be traded on the blockchain just like any other cryptocurrency. Each colored coin represents a specific asset, which can be tracked and verified on the blockchain. This allows for the tokenization of real-world assets, such as stocks or bonds and property, making it easier to trade and transfer ownership.

All transactions involving colored coins can be tracked and verified on the blockchain, which makes it difficult for fraud or other illegal activities to take place. Additionally, because colored coins are backed by Bitcoin, they inherit the security and immutability of the BTC blockchain, making them a secure and reliable way to represent assets on the blockchain.

Use Cases for Colored Coins

Colored coins were proposed for a wide range of industries, from gaming to finance, and implemented to a certain extent. They enabled the tokenization of assets on the blockchain, making it easier to trade and transfer ownership. Colored coins also opened up new possibilities for decentralized finance (DeFi) and helped in some ways to bridge the gap between traditional finance and the blockchain.

Given that colored coins enabled asset tokenization, colored coins were largely used for the following:

  • Asset Representation: Colored coins could be used to represent real-world assets digitally. For example, one could create tokens via colored coins that prove ownership of physical assets like real estate, commodities, or even art.
  • Tokenized Securities: Colored coins could be utilized to tokenize traditional securities such as stocks, bonds, or company shares. This enabled easier and more efficient transfer and trading of these assets.
  • Loyalty Programs: Companies could issue colored coins as digital tokens to create loyalty programs. These tokens could be distributed to customers as rewards and can be redeemed for discounts, special offers, or exclusive products or services.
  • Collecting Virtual Assets: Colored coins were used in online gaming platforms to represent virtual assets, such as in-game items, characters, currency, or on other platforms in the form of collectibles (much like the trading cards initially seen on Counterparty). This allowed players to sell, own, trade and manage these assets securely.
  • Intellectual Property Rights: Colored coins could be used to represent ownership or licensing rights for digital content, such as music, videos, or eBooks. This would enable creators to distribute and monetize their work while ensuring ownership is properly recorded.

These are only some of the use cases that were proposed and, to varying degrees, implemented for colored coins, as the idea was that colored coins could represent anything (almost) on the public blockchain.

The Use of Colored Coins: A Revival?

As more industries begin to adopt blockchain technology, the need for asset tokenization and trading on the blockchain will only grow. While colored coins were overshadowed by other developments in the crypto space, the concepts they pioneered are likely to play a major role in the evolution of additional technology on Bitcoin.

The developments pioneered by colored coins have given way to everything from the concept of an NFT to additional protocols like the RGB protocol we mentioned in the beginning, and Bitcoin layers themselves. In conclusion, colored coins have been a transformative concept, and colored coin wallets served as the gateway to unlock the full potential of digital assets. By leveraging these wallets, individuals and businesses could navigate the world of tokenized assets and more, opening up avenues for innovation, efficiency, and decentralized management of digital assets.