What are Colored Coins? The Ultimate Guide

While not well known or widely used, colored coins could very well be the beginning of Bitcoin 2.0 as they expand the utility of the Bitcoin blockchain. The colored coins are tokens that are representations of real world assets on the blockchain. You can use colored coins to prove ownership of any physical asset, from precious metals to cars to real estate, or equities and bonds. And they are extremely easy to issue.

Colored coins offer some very interesting features, but they haven’t really caught on, and aren’t being used widely. One reason for this is the creation of the Ethereum blockchain and the fairly mass adoption of ERC-20 tokens. The best use case so far for colored coins has been in creating an ICO. An ICO can be done using colored coins in minutes and with little cost. Unfortunately we haven’t seen many business spring up to take advantage of this ease of use case. In fact, the leading colored coins wallet and service, Coinprism, shut down at the beginning of April 2018.

Flavien Charlon, the founder and CEO of Coinprism, had this to say about the decision to shutdown the Coinprism services:

“While we have been one of the first in the area of blockchain tokens, long before ethereum was even released, the ecosystem has since shifted towards ERC-20, which is more flexible and more powerful than bitcoin-based systems.”

While colored coins will almost certainly have a role to play in the future of Bitcoin, without mainstream adoption they could fall to the increased acceptance of Ethereum based solutions. Of course the technology is still very young, and much could change in coming years.

What are Colored Coins?

Colored coins were created as a way to issue and transfer assets on the Bitcoin blockchain. A colored coin can be issued to represent anything at all, including stocks, bonds, commodities, real estate, fiat currencies and even other cryptocurrencies.

You can try to think of each Bitcoin (actually each satoshi – the smallest fraction of a Bitcoin that can currently be transferred), as billions of identical blank sheets of paper. All these sheets are created by the Bitcoin network as part of its verifications. When each sheet is created it is blank, and represents only itself.

Prior to a programming change made on April 19, 2014 any attempt to add additional information, or “write” on the papers would have caused the Bitcoin to be destroyed. The network would no longer recognize the “corrupted”. To get around this, users began adding extra bits of data to transactions to include messages or other information. The community saw this as bloating and polluting the blockchain, so a function was added that allowed adding information to a Bitcoin without making it unspendable. This made colored coins a reality, and it is no possible to add information such as “This represents one ounce of gold” or “This is an IOU for $500 owed to Rob Turner of Miami, Florida”. These colored coins can be transferred and the owner of the coin is also the owner of the asset represented by the coin.

This makes it possible for a company to do an IPO in minutes and practically for free using colored coins. Through ChromaWallet they can create and issue their shares, which can then be freely exchanged on the Bitcoin blockchain instantaneously, globally, and with minimal fees.

Colored coins could eventually replace many expensive and time consuming financial transactions. For example, in the real estate sector a colored coin could be used to represent the deed for a house, commercial property, or block of land. The owner of the coin becomes the owner of the physical property, and transferring it is as quick and easy as making a Bitcoin transfer.

The Potential of Colored Coins

Because the Bitcoin network runs on the internet, it is accessible by any internet connected device, anywhere in the world. Making a Bitcoin transaction can be as simple as sending an SMS or email, transferring value directly in a peer-to-peer fashion, without the need for any third party intermediary. And since colored coins are a type of Bitcoin, this is true when discussing colored coins as well. This should begin to give you some idea of the potential that colored coins hold.

Think of any financial instrument you like, whether it be common stock, company bonds, or even exotic financial products such as futures or derivatives. Currently these financial instruments need to be issued by banks or companies, and traded on centralized exchanges such as the New York Stock Exchange or the Chicago Mercantile Exchange. With colored coins all these layers can be removed, and anyone could issue their financial product on the Bitcoin blockchain and they could then be traded worldwide to anyone with an internet connected device. Fees and commissions would be gone, and transfers would be instantaneous.

This even opens up the possibility for assets that current aren’t traded to become a reality. Because the cost for creating a colored coin is minimal anyone could use them to sell assets. So, something like eBay could become blockchain based. Or a young entrepreneur could easily raise capital for their new bakeshop by issuing an IPO. Think of it as crowd funding on the blockchain. Any person, anywhere in the world, could have access to global capital markets.

Going beyond the small entrepreneur this means a small farming operation in Indonesia could find investors in France to help them expand. A new business being created in Argentina might find investors in Japan. An artist in Scottsdale Arizona can get funding from fans to continue producing new works of art, even selling them ahead of time as colored coins.

It is quite literally impossible to imagine the tidal wave of innovation and economic growth that such an egalitarian system of capital formation would unleash.

Colored Coins Risks

It’s unrealistic to think that there won’t be some risks to colored coins. While they are part of the Bitcoin blockchain, they are quite different from ordinary Bitcoin, since they represent real-world physical assets and financial obligations. This means every colored coin needs to be issued by an individual or organization, which adds a layer of risk. The possibility will always exist that the issuer of the colored coin will fail to honor the obligation inherent in the coin. There is even the risk that they don’t represent anything real at all, and are completely fraudulent.

Because of these risks regulations will inevitably be necessary, but it’s important that regulators approach the issue with an open mind. After all, we can still effectively use email, even though the technology opened us up to the opportunity of helping Nigerian princes recover vast sums of money from abandoned bank accounts. There’s no doubt that colored coins will present us the opportunity to buy that proverbial bridge in Brooklyn, or to invest in imaginary gold mining operations. People have learned to recognize phone based scams, and later email based scams, and even ICO scams to some extent, and they’ll become adept at recognizing blockchain based scams being carried out with colored coins as well. And we will still be able to use the technology as it was intended, reaping the full benefits.

At this time the biggest disadvantage to colored coins is the lack of wallets that support colored coins. And with Coinprism shutting down that situation has become somewhat worse, although the ChromaWallet could easily fill the void.

Colored coins also have stiff competition from the Ethereum based ERC-20 tokens, and to date it appears that the community has decided to go with the Ethereum based solution, although that could change as the Bitcoin blockchain evolves and improves. If Bitcoin becomes easier to use, or cheaper, or faster, then colored coins could once again have an advantage. This is all very new technology and anything that improve usage is good for the future of crypto in general.

What options are there for color-aware wallets?

Coinprism was the best option for a color-aware wallet for a long time, but with their closing I can think of just two other options.

ColoredCoins.org has a wallet called BankBox that is color-aware.

Additionally, ChromaWallet is a beta color-aware wallet that is showing a good deal of promise.

In Conclusion

Even though they’ve been in existence for four years, the state of colored coins remains quite immature, probably because of the completion that came from the Ethereum blockchain, which arguably does a better job in some respects. Even with Ethereum though we still don’t have any use case where we’re seeing stocks or any other financial product being traded on the blockchain.

Additionally, there are few wallets supporting colored coins, and without additional wallets, it will remain difficult to use colored coins effectively. Plus there are only a few projects exploring the colored coin use cases, and with Coinprism shutting down a hard blow has been struck to the colored coin community. There is a good deal of work that will need to be done to make colored coins a viable alternative for storing physical assets on the blockchain.

In fact, with the rise of projects such as Bytom, which seeks to digitize the physical world, or DigixDAO, which is building a gold backed cryptocurrency and could use its technology to create coins backed by any physical asset, the colored coin could become a footnote in history.