Colored Coins

Colored Coins is an open-source protocol that allows users to represent and manipulate immutable digital resources on top of Bitcoin transactions. They are a class of methods for representing and maintaining real-world assets on the Bitcoin blockchain, which may be used to establish asset ownership. Colored coins are bitcoins with a mark on them that specifies what they may be used for. Colored coins have also been considered a precursor to NFTs.
Although bitcoins are fungible on the protocol level, they can be marked to be distinguished from other bitcoins. These marked coins have specific features that correspond to physical assets like vehicles and stocks, and owners may use them to establish their ownership of physical assets. Colored coins aim to lower transaction costs and complexity so that an asset's owner may transfer ownership as quickly as a Bitcoin transaction.
Colored coins are commonly referred to as meta coins because this imaginative coloring is the addition of metadata. This enables a portion of a digital representation of a physical item to be encoded into a Bitcoin address. The value of the colored coins is independent of the current prices of the bitcoin; instead, it is determined by the value of the underlying actual asset/service and the issuer's desire and capacity to redeem the colored coins in return for the equivalent actual asset or service.

History

Colored coins arose due to the necessity to generate new tokens and move assets on the Bitcoin network. These tokens can be used to represent any asset in the world, including equities, commodities, real estate, fiat currency, and even other cryptocurrencies.
Yoni Assia, the CEO of eToro, was the first to suggest Colored coins in an article published on March 27, 2012. In the article titled bitcoin 2.X, Assia claimed that the initial specifications that bitcoins transmitted using the "Genesis Transaction" protocol are recognizable, distinctive, and trackable on the ledger. The idea was growing, and on forums such as Bitcointalk, the concept of colored coins started to take form and gain traction. This culminated in Meni Rosenfeld releasing a whitepaper detailing the colored currencies on December 4, 2012.
The next year, in 2013, Assia collaborated with Buterin and five others, Lior Hakim, and Meni Rosenfeld, Amos Meiri, Alex Mizrahi and Rotem Lev to write Color Coins — BitcoinX, which explored the potential possibilities of colored coins.
In 2013, the New Scientist magazine first acknowledged Colored Coins where Meiri describes for the first time the actual issuance of a share or a gold bar on the blockchain. In 2014, Colu was the first company to raise venture capital money to develop the Colored Coins protocol.

Development

Colored coins originated as an afterthought by Bitcoin miners. The blockchain's data space had been utilized to encode numerous metadata values. This unexpected data caused processing issues, causing the network to slow down. The Bitcoin team fixed the problem by including a 40-byte area for storing data as a transaction, as well as an encrypted ledger of transactions and information about the coin's genesis.
While bitcoin was developed to be a cryptocurrency, its scripting language makes it possible to associate metadata with individual transactions. By precisely tracing the origin of a particular bitcoin, it is possible to distinguish a group of bitcoins from the others, a process known as bitcoin coloring.
Through the oversight of an issuing agent or a public agreement, special properties can be associated with colored bitcoins, giving them value beyond the currency's value. One way of looking at this is from the abstraction that there are two distinct layers on top of bitcoin: the lower layer referring to the transaction network based on cryptographic technology and an upper layer that constitutes a distribution network of values encapsulated in the design of colored coins.
Due to the fact that colored coins are implemented on top of the Bitcoin infrastructure, allow atomic transactions and can be transferred without the involvement of a third party, they enable the decentralized exchange of items that would not be possible through traditional means.
To create colored coins, "colored" addresses must be created and stored in "colored" wallets controlled by color-aware clients such as Coinprism, Coloredcoins, through Colu, or CoinSpark. The "coloring" process is an abstract idea that indicates an asset description, some general instructions symbol, and a unique hash associated with the Bitcoin addresses.
In 2013, Flavien Charlon, the CEO of Coinprism, developed a Colored Coin Protocol that permitted the generation of colored currencies by employing specified settings in transaction inputs and outputs. This was Bitcoin's first working Colored Coin Protocol. This protocol, also known as the Open Assets Protocol, is open source and may be integrated into existing systems by anyone.
On July 3, 2014, ChromaWay developed the Enhanced Padded-Order-Based Coloring protocol, which simplified the process of manufacturing colored coins for developers, and was one of the first to employ Bitcoin Script's new OP RETURN function.
In January 2014, Colu created the ColoredCoins platforms and Colored Coins protocol allowing users to build digital assets on top of the Bitcoin blockchain using the Bitcoin 2.0 protocol. In 2016, Colu announced integration to Lightning Network expanding its Bitcoin L2 capabilities.

Layers of Colored Coins

Colored coin functions by adding a 4th layer to the Bitcoin blockchain.

1st Layer: Network
2nd Layer: Consensus
3rd Layer: Transaction
4th Layer: Watermark

Before ERC token standards were created, the concept of using tokens to represent and monitor real-world items existed. Colored coins were the original notion for representing assets on the blockchain. They are not widely used because the transaction structure required to represent colored coins relies on unspent transaction outputs, which Ethereum-based blockchain systems do not support. The primary concept is to add an attribute to native transactions that specify the asset it symbolizes. For example, for the Bitcoin blockchain, each Satoshi might represent a separate item. This notion is mostly used to monitor ownership of tokens and, by extension, assets. There is promise in using colored coins as an effective way of tracing in production situations since the transactions can be merged or divided into new transactions and the color can be readily altered after each transaction. Finally, current tools, like as blockchain explorers, make it simple to view and analyze transactions.
The nature of colored coins makes them the first non-fungible tokens to be created on the Bitcoin blockchain, albeit with limited features. Colored coins are transferrable in what is known as atomic transactions. Atomic transactions are transactions that permit the direct peer-to-peer exchange of one token for another in a single transaction. In this way, colored coins allow traditional assets to be decentralized.

Transactions

Colored coin uses an open-source, decentralized peer-to-peer transaction protocol built on top of WEB 2.0. Despite being created to be a protocol for monetary transactions, one of the Bitcoin's advantages is a secure transaction protocol not controlled by a central authority. This is possible through the use of Blockchain, which maintains track of all Bitcoin transactions worldwide.
A transaction consists of:

A set of inputs such that each input has a Transaction Hash and Output Index of a previous transaction carried out on that bitcoin and a digital signature that serves as cryptographic proof that that input address authorizes the transaction.
An output set such that each output has the bitcoin value to be transferred to that output and a script that maps a single address to that output.
Staining and transferring

The manipulation of colored coins can be performed through several algorithms, which create a set of rules to be applied to the inputs and outputs of Bitcoin transactions:

At a given moment, a digital resource is associated with the output of a Bitcoin transaction, called Genesis Transactions. The output of this transaction belongs to the initial owner recorded in the system.
When the resource is transferred or sold, the currency that belongs to the previous owner is consumed, while a new colored currency is created at the outgoing address of the transfer transaction.
When it is necessary to identify the owner of a coin, it is enough to evaluate the transaction history of that coin from its genesis transaction to the last transaction with unconsumed output. The Bitcoin blockchain has tracking of the public keys associated with each address, such that the owner of the coin can prove ownership by sending a message with the private key associated with that address.

Among these algorithms, the best known of them is the EPOBC. The EPOBC algorithm colors the coins by inserting a mark in the nSequence field of the first input of the transaction. It is important to note that the nSequence field is always present in Bitcoin transactions, but it is not used, so it does not generate an overhead for the coloring process. Examples of companies driving the EPOBC are ChromaWallet, Cuber, LHV and Funderbeam.

Genesis transactions

To issue new colors, it is necessary to release coins of that color through genesis transactions. In general, there are two cases to consider about genesis transactions:

Non-reissuable colors: In this case, the transaction inputs are irrelevant to the algorithm, since once the transaction is executed, the coin issuer has no power over them. So all that matters is the genesis transaction itself.
Reissuable colors: In this scenario, the issuer must choose a secure address to be the “Issuing Address” and set transaction entry 0 to come from that address. In a second moment, the issuer will be able to issue new units of that color through genesis transactions with the same secure address. It is important to note that an address can only be associated with a single color. Once an address emits a reissuable color, it will no longer be able to participate in coloring coins of other colors, not even non-reissuable colors.