Colored Coins and the Way they Work

Fredrick Awino
19.07.2022
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Cryptocurrencies continue growing and new terminologies keep emerging to enrich the wider field of virtual currencies. Notably, some terms have also been with us for a while but re only coming to know them now that cryptocurrencies are fast becoming a household name. One such name is colored coins.

WARNING: Investing in crypto, or other markets, can be of a high risk for your savings. Do not invest money you cannot afford to lose, because there is a risk for losing all of your money when investing in crypto, stocks, CFDs or other investments options. For example 77% of retail CFD accounts lose money.

The term colored coins may evoke first impressions of gold, silver, bronze et cetera which cryptos have been depicted to look like. Instead, the terminology is more about the technical aspects of cryptocurrency transactions than colour as it were.

Colored coins refer to the way of transferring and issuing assets in the Bitcoin blockchain. It is unique in that it is encoded with unique information to differentiate it from the other assets. Also, a colored coin is mainly a denomination of Bitcoin repurposed by marking it with metadata.

The History of Colored Coins

The colored coins came about because of the need of generating new coins as well as moving assets in the Bitcoin network. Through these tokens, there is a possibility of representing anything including fiat currencies, real estate, commodities, and stocks.

In 2012, on March 27th, Mr. Yoni Hesse who is the CEO of eToro a paper. “The paper was titled ‘bitcoin 2. X,’ also known as colored coins. According to the paper, the first specifications regarding the transmission of bitcoins using the “Genesis Transaction” protocol are trackable, distinctive, and recognizable on the ledger. The idea has highly grown in various platforms including Bitcointalk. It is during this time that the colored coins commenced gaining traction and taking form.

Furthermore, on 2012 December 4th, Meni Rosenfeld created a whitepaper to explain colored coins. According to him, it was important to take advantage of the fungibility of Bitcoin. This is done by segregating several coins from the others because of special purposes. Meni’s work was the first colored coin formal work and it captured the attention of many people.

The Way Colored Coins Work

In colored coins, color means the process used in making something distinct. There are different steps in the way colored coins work. The first one is the transaction genesis. In releasing the colored coins, it is important to initially generate a genesis block. It means that after the creation of metadata, it is then added to the chain’s original block. The reason is that it set rules for future transactions.

The second step is transferring the transaction. After creating the colored coins in a blockchain, they should be sent. It is through this that a transfer transaction is performed. Remember, you need the capacity of sending colored coins from one wallet to another. Also, the two addresses should recognize the coin and this is to ensure that output and input data should sync up.

In the third step, we go to coloring algorithms. They refer to mechanisms allowing transactions to take place with regard to the predefined rules. The different coloring algorithms include Order-based Coloring (POBC), Tagging-based Coloring (TBC), and Order-based Coloring (BC). They perform the same functions.

The above mechanisms offer a structure for the transections and inform the receiver as well as the sender of the color coin with the following:

  • Details of the code and script meaning the outputs data
  • The network’s color balance, that is, all the inputs.
  • Outputs’ size regarding the network
  • The outputs’ position means the coins in the transaction that are relative to the inputs

The Pros of Using Colored Coins

The first benefit of the colored coin is that it lives in the blockchain of Bitcoin. This means that it is highly secured with massive investment in hardware supporting the network. Moreover, through it, you may develop an unlimited number of coins. These are the coins that do not require their network or even dedicated hardware.

Furthermore, in colored coins, there is a possibility of tokenizing different assets. Also, through the colored coins, there is a possibility of developing several coins that do not need their own hardware or network. Lastly, they extend decentralized exchanges use.

The Cons of Colored Coins

Even though the colored coins are good, they have their disadvantages. The first one is that there are no several choices that a trader may choose from. Since there are just a few varieties, you may have assets sent to any Bitcoin address but you need to generate an asset address in receiving them. On the other hand, any Bitcoin address may hold the colored coins. The main limitation of this process is that since colored coins are selected by special data and transactions in the blockchain, in case the transaction holding it is used to send funds then the coin can be destroyed.

The Cases When We Can Use Colored Coins

Colored coins can be used in managing and trading access as well as subscription services. Netflix or even a museum may offer passes as colored coins. Another use is a company that may need to offer shares using colored coins. This gives traders the chance of maintaining ownership of stocks and shares. You can read ‘stocks versus cryptocurrency’ to understand the way stock works. They can also perform activities such as paying dividends, voting, and trading.

A colored coin can be used as smart property. For instance, if there is a card rental property, a firm may release a colored coin to represent every car. The car is only figured out after getting a signed message with a private key currently owning the colored coin. The smartphone app can be released and any person can utilize it in broadcasting a message which is signed with the private key. It means that you can buy the colored coin and then use the car for a certain period of time. After that, you will use the car key or rather the smartphone app then sell the coin again later.

Colored coins act as exchange systems. It means that they are treated like Bitcoins based on the way they work. This also makes them be treated as OP_RETURN script. Through this, there is a possibility of performing payment systems using them. The colored coins can also perform atomic exchanges. In some ways, the colored coins are linked to non-fungible tokens. It means that they create collectibles. For instance, after making a payment with a colored coin, ownership is passed to another person.

Author Fredrick Awino