What are colored coins?
Colored coins are cryptocurrencies that have unique metadata associated with them. This metadata marks a colored coin as distinct from other cryptos. While the crypto used to make a colored coin has the same fiat value on the open crypto market, it contains special features thanks to the addition of this metadata.
When developers create Bitcoin (BTC) colored coins, the underlying Bitcoin is worth the same as any other Bitcoin. However, colored bitcoins have additional non-monetary benefits thanks to their metadata. Typically, the metadata in a colored coin grants holders access to special perks or ownership rights.
Historical records suggest Meni Rosenfeld of the Israeli Bitcoin Foundation published the first colored coins white paper in 2012. A year later, Ethereum's co-founder Vitalik Buterin and eToro's Yoni Assia published another paper detailing colored coins.
Initially, blockchain developers were only interested in using Bitcoin's blockchain to code colored transactions. To this day, colored coins are most associated with Bitcoin, but they can exist on other blockchains like Bitcoin Cash, Litecoin, and Dogecoin.
How does coloring work?
In the early 2010s, blockchain developers used specific inputs and outputs when coloring a BTC transaction, but today, they rely on the blockchain's OP_RETURN Script. Coders can link roughly 80 bytes of data to a specific BTC transaction and signal this information to nodes via OP_RETURN. Typically, when developers color a cryptocurrency, they use small amounts of digital assets. For example, Bitcoin colored coins can be just a few hundred Satoshis. (For context, one Satoshi equals 0.00000001 BTC, or about $0.0002 if one BTC is worth $20,000.)
An issuer can send their colored coin on the blockchain like any other crypto transaction, but they need a crypto wallet designed to decipher colored messages.
Unlike layer-2 solutions like the Bitcoin Lightning Network, colored coins usually aren't used to send monetary value between crypto users. Instead, these coins are meant to grant holders the unique benefits and features associated with the metadata. Therefore, the market value of a colored coin isn't as significant as a non-colored cryptocurrency.
What are the benefits of colored coins?
Colored coins helped introduce blockchain technology’s uses beyond peer-to-peer (P2P) payments and alternative investments. Here are some other benefits of colored coins:
- Expand the use cases of cryptocurrency: Colored coins helped generate excitement about the limitless possibilities of blockchain technology. Not only did these coins give developers greater flexibility, but they also gave non-crypto-related firms, companies, and institutions a potential reason to use crypto in their business strategies, enabling them to increase the adoption of blockchain technology.
- Support the security, longevity, and global reach of the Bitcoin blockchain: Although colored coins exist on other blockchains, most use the Bitcoin Network. As the largest and oldest cryptocurrency, Bitcoin has the highest reputation for security, allowing developers to instantly reap the advantages of the global BTC blockchain.
- Offer enhanced transparency to issuers: Colored coins allow companies, institutions, or nonprofit organizations to maintain transparency in their internal systems. Since all transactions are verifiable on a public blockchain, it's easy to verify which wallets hold these coins and where they're being transferred.
- Facilitate wide user reach: While it's not as simple to create a colored coin versus an NFT, developers with coding experience can use this technology. Portals like GitHub offer plenty of open-source data on colored coins.
Are there any drawbacks to colored coins?
Colored coins have unleashed a wealth of opportunities for blockchain developers, but there have been a few negative features associated with these cryptocurrencies. Also, as new blockchain technologies gain prominence, colored coins have lost some appeal. Here are some of the most prominent disadvantages of colored coins:
- Higher learning curve to create and use: Although anyone can create colored coins, it's more challenging to use this technology without prior coding experience. There are also fewer services available to make colored coins than minting NFTs.
- Declined popularity due to NFTs: Many involved in crypto have shifted their focus to NFTs as they are more accessible in today's market and offer greater ease and flexibility to developers than colored coins.
- Potential legal challenges for coins that track securities: If colored coins are associated with third-party assets like stocks or bonds, they may fall under the jurisdiction of government institutions, which may cause significant legal and tax implications. The U.S. Securities and Exchange Commission already oversees security tokens on smart contract blockchains.
- Lack of incentives for miners: Since most colored tokens are insignificant in terms of fiat currency, sending them won't generate high fees on proof-of-work (PoW) blockchains like Bitcoin. Due to these low fees, crypto miners likely won't prioritize colored coin transactions, which can lead to increased congestion and slow throughput for those using colored coins.
What are the potential uses of colored coins?
The applications of colored coins are endless, but most involve granting holders access to unique features, events, or even real-world properties. A few potential use cases of colored coins include:
- Rewards or loyalty programs: Businesses can offer return customers colored coins as loyalty points, rewards, or coupons. Once customers meet a threshold of colored coins, they can redeem these coins for free or discounted items like food, movie tickets, or coffee.
- Tokenized securities: Executives can issue stock in their companies via colored tokens. Employees holding colored coins in their portfolios can use them to exercise voting rights, collect dividends, or trade on the associated blockchain.
- Fundraiser tracking and transparency: Charity groups usually consider coloring their crypto donations to improve trust with the community. Since colored coins are easier to track, a fundraiser can verify where donors' funds are going, enhancing transparency.
- Virtual collectibles: Many crypto enthusiasts first became aware of colored coins due to their association with virtual trading cards. Colored coins like Spells Of Genesis and Rare Pepe cards on the platform Counterparty are considered proto-NFT collectibles similar to CryptoPunks and the Bored Ape Yacht Club (BAYC).
- Property rights: A colored coin can include legally binding documentation that grants holders access to a property like a colored coin can double as a mortgage deed.
Can any crypto become colored tokens?
Most often, when crypto enthusiasts talk about coloring coins, they're referring to Bitcoin, which is primarily because of BTC’s dominance in the crypto market. Also, when developers began formulating the colored coin technology, there weren't as many cryptos to choose from. However, it's possible to color any crypto asset with specific metadata.
Are colored coins the same as NFTs?
Most people in the crypto community view colored coins as the precursor to NFTs. In many respects, colored coins and NFTs have the same features, serve similar purposes, and represent unique ownership privileges on a blockchain.
But there's a noteworthy distinction in how these cryptocurrencies operate. Unlike colored coins, NFTs rely on autonomous smart contracts to validate ownership on top of a blockchain. In contrast, developers who create and send colored coins transfer a cryptocurrency like Bitcoin that already has a market value on its native blockchain.
While NFTs are connected to whatever smart contract blockchain they're on, they are distinct from the chain's native crypto asset. For example, a Bored Ape NFT on Ethereum uses an Ethereum token standard called ERC-721, which isn't the same as Ethereum's native currency ETH. A colored coin, however, makes use of a native crypto asset like BTC or ETH.
Colored coins don't receive as much attention as NFTs, but they played a vital role in the history of crypto. It's unlikely blockchain developers would have thought to create NFTs or smart contracts without the foundations of colored coin technology. Also, since colored coins are often linked to real-world assets, many suspect they may have inspired the creation of fiat-pegged stablecoins and security tokens.
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