Bitcoin Colored Coins

Information

Created: 1 March 2012
Creator: Yoni Assia
Blockchain: Bitcoin

Description

When Bitcoin Tried to Become More Than Money

In 2012, a small group of developers began exploring an idea that sounds straightforward today: what if a bitcoin could represent something other than money? A particular unit might stand for a company share, a claim on a bar of gold, a ticket or a digital collectible. Instead of creating a new blockchain for every kind of asset, why not use the Bitcoin network that already existed?

This was the thinking behind Colored Coins, a collection of experiments that developed between 2012 and the middle of the decade. The developers were trying to solve a problem that would later become familiar to anyone interested in NFTs: how can a digital token represent ownership of something when the underlying information can be copied perfectly?

Giving a bitcoin a second identity

Bitcoin treats its units as interchangeable. One satoshi, the smallest unit of bitcoin, is worth the same as any other satoshi. That is exactly what you want from money, but it creates a problem when you want a particular unit to represent something else.

Colored Coins offered a way around this by tracking the history of selected units. A transaction would establish a new asset, and specialised software would follow the associated satoshis as they moved between addresses. The software could then distinguish them from ordinary bitcoin and recognise them as units of the new asset.

The colour was only a metaphor. Nothing changed in the underlying bitcoin, and Bitcoin's network did not know that a particular unit represented a company share or a digital collectible. To the network, it was still just bitcoin. The additional meaning existed in the rules followed by software that understood the relevant protocol.

The first public proposal appeared on 27 March 2012, when Yoni Assia, then associated with the online investment platform eToro, published bitcoin 2.X (aka Colored Bitcoin). His idea was not limited to digital collectibles. Assia was interested in creating alternative currencies that could use Bitcoin's existing infrastructure for transactions and security.

Rather than building a separate payment network for every new currency, a community could issue its own units and use Bitcoin to transfer them. The blockchain would record the transactions, while the rules of the new asset would determine what those units represented.

It was an appealing shortcut. There was no need to persuade the world to adopt another cryptocurrency before experimenting with a new kind of digital asset. But it also raised a question that would follow Colored Coins throughout its development: Bitcoin could record a transaction without understanding what the transaction meant.

From an idea to a protocol

On 4 December 2012, mathematician and cryptographer Meni Rosenfeld published Overview of Colored Coins, giving the concept a more formal technical treatment. Rosenfeld, then president of the Israeli Bitcoin Association, described ways to distinguish particular units of bitcoin and follow their ownership through the transaction history.

The possible applications extended well beyond alternative currencies. Shares and bonds were obvious candidates, as were certificates representing commodities such as gold. A company could issue digital shares that changed hands through Bitcoin, while a community could create a currency without maintaining its own blockchain.

Other uses were less conventional. A token might represent a ticket, subscription or right to use a physical object. In one proposed example of smart property, a rental car could be designed to start only when its current authorised user supplied the correct cryptographic signature. Transfer the digital key, and the right to use the car could pass to someone else. The car itself would not move, but the record of who was entitled to use it would change.

Digital collectibles fitted into the same picture. The Bitcoin Wiki's account of Colored Coins lists songs, films, e-books and software among the things that could be represented by coloured units. A digital file could still be copied, but a token could record who held a particular ownership claim or right of access. Those were two separate problems, and the distinction would become central to the later history of NFTs.

The basic process had three stages. An issuer created an asset in a genesis transaction. Specialised software then tracked the asset as its associated units moved between Bitcoin addresses. To verify ownership, the software followed the chain of transactions back to the original issuance and established that the current holder controlled the relevant unspent transaction output, or UTXO.

That last step could become awkward. Bitcoin does not maintain balances in quite the same way as a conventional bank account. It records transaction outputs that can be spent, with later transactions consuming them and creating new outputs. Colored Coins software had to determine how an asset moved through this history, sometimes tracing a long chain of transactions to establish its identity.

Developers experimented with different rules for doing this. Early Order-Based Coloring methods used the order and values of transaction inputs and outputs to determine which units retained their colour. Later approaches added padding or used transaction markers to make the interpretation more reliable.

The concept was easy enough to explain. Making every wallet interpret it correctly was another matter.

Several ways to colour the same coins

By late 2013, Colored Coins had become a family of competing protocols rather than one agreed standard. Different teams wanted to issue and transfer assets through Bitcoin, but they did not all use the same methods to identify them.

One important development was the Open Assets Protocol, created by Flavien Charlon and documented in a specification dated 12 December 2013. It used a special marker in a Bitcoin transaction, with an OP_RETURN output carrying information that helped compatible software recognise the asset. The Open Assets specification set out rules for issuing and transferring assets on the Bitcoin blockchain.

ChromaWay took a different approach with Enhanced Padded Order-Based Coloring, usually called EPOBC. It used tags in an existing transaction field, nSequence, allowing compatible software to identify issuance and transfer transactions without relying on the same marker-output method used by Open Assets.

CoinSpark developed compact transaction encoding and support for lightweight wallets. Colu built another implementation and began developing tools for businesses and software developers who wanted to issue their own assets.

These projects were not merely theoretical exercises. Estonia's LHV bank used ChromaWay's technology to issue €100,000 worth of claims on the blockchain, while Funderbeam used it in its startup-investment market. The Bitcoin Wiki's historical account records both examples.

Colu attracted venture capital as well. In January 2015, the company announced a $2.5 million seed funding round to develop its technology. Investors were being asked to back the idea that digital assets could be issued and transferred using an existing blockchain, with applications beyond cryptocurrency trading.

But there was a practical catch. The protocols were not interchangeable. Software that understood an asset issued under one system could not necessarily recognise an asset created under another. Everyone was using Bitcoin, but they were not necessarily speaking the same language.

Attempts to bring the different approaches together around a common standard struggled. In a January 2015 forum post, Colu's team described the divisions that had emerged and the difficulty of establishing a shared system. Each project had its own implementation and priorities, making cooperation harder than the underlying idea might suggest.

For users, the problem was straightforward enough: an asset might be perfectly intelligible to one wallet and meaningless to another. The hope had been to use a common blockchain as the foundation for different kinds of ownership. In practice, the software interpreting that blockchain could disagree about what it contained.

The danger of losing the colour

The deeper problem was that Bitcoin itself did not enforce the rules of Colored Coins.

A coloured satoshi remained ordinary bitcoin as far as the network was concerned. If its owner spent it using a wallet that did not understand the relevant protocol, the transaction could be valid on Bitcoin while destroying the asset's identity. The underlying bitcoin would still reach its destination, but the coloured asset might not survive the transfer.

Think of it as a document carrying a claim that only certain people know how to interpret. The postal service can deliver the document perfectly well, but it cannot guarantee that the claim written on it will be honoured. Bitcoin secured the transfer of its own currency; additional software had to ensure that a transaction also made sense under the rules of a coloured asset.

Verification presented another difficulty. To establish that a coloured unit was valid, software might need to trace its history back to the original issuance. As that history grew, the work required to follow it could become expensive. Lightweight wallets faced a particular challenge because they were designed to avoid downloading and checking the entire blockchain.

Bitcoin's scripting capabilities placed further limits on what developers could build. Colored Coins could represent and transfer assets, but implementing more elaborate financial arrangements required additional mechanisms outside Bitcoin's ordinary transaction rules.

There was also a limit that no transaction format could overcome. A token might represent a claim on a bar of gold, but the blockchain alone could not guarantee that the issuer owned the gold or would deliver it when asked. The token's value depended on the issuer's promise and on the legal and practical arrangements behind it. Recording a claim and enforcing that claim were different things.

For a digital collectible, the arrangement might be relatively simple. For company shares, property rights or substantial financial assets, the distinction mattered considerably more.

An idea that helped shape Ethereum

One of the people exploring the limits of Bitcoin-based assets was Vitalik Buterin, who later co-founded Ethereum. It is tempting to draw a straight line from Colored Coins to Ethereum, as though the limitations of one system directly produced the other. The history is more complicated.

In a 2014 retrospective on Ethereum's early development, Buterin recalled meeting the core teams behind Colored Coins and Mastercoin during a visit to Israel in October 2013. His account places his work on Mastercoin and a proposal he called ultimate scripting closer to the immediate origins of Ethereum.

The broader problem was similar across these experiments. Developers wanted blockchains to do more than transfer their native currency. They wanted to represent assets and make transactions follow rules defined by the people using them. But Bitcoin's scripting language and transaction model made some of these tasks difficult, while verifying the resulting assets could require software to reconstruct long histories of transactions.

Buterin began looking towards a different architecture: a blockchain capable of supporting general-purpose computation and smart contracts. Rather than build every new application around Bitcoin's existing transaction rules, Ethereum would provide a platform on which developers could write more complex programs.

Colored Coins did not single-handedly produce Ethereum, and Ethereum was not simply Colored Coins moved to another blockchain. Both belonged to a period of experimentation in which developers were discovering how much functionality could be added to Bitcoin and where a different approach might be preferable.

Some wanted to keep Bitcoin as the common foundation and build asset protocols on top of it. Others began exploring whether a blockchain designed to support more general applications would make the job easier.

Colored Coins are often described as precursors to NFTs, and the connection is genuine. The early proposals explored how a blockchain could record the transfer of identifiable digital assets, including media and collectibles, years before NFTs became a familiar term.

Calling them the first NFTs, however, goes further than the evidence comfortably allows. Many of the assets envisaged by Colored Coins were meant to be interchangeable. One share in a particular class of company could be equivalent to another share in the same class, just as one unit of a community currency could be exchanged for another. That is different from a non-fungible token intended to identify a particular item.

What matters historically is the question the developers were trying to answer. Could a public blockchain record ownership of assets other than its own currency? Could it track the movement of those assets without requiring a separate blockchain for each one? And could the system do this reliably enough that other people would trust the result?

Related experiments continued with Mastercoin's successor, Omni Layer, and Counterparty. Counterparty would later support projects such as Rare Pepes and Spells of Genesis, bringing Bitcoin-based digital collectibles into a more recognisable form. Much later, Ordinals and other Bitcoin token protocols would revisit the question of how individual units and transaction data could carry meaning beyond ordinary payments. These systems work differently, but they belong to the wider history of attempts to represent assets on Bitcoin.

By the second half of the 2010s, the original Colored Coins ecosystem had lost momentum. The different implementations had struggled to establish a common standard, verifying assets remained cumbersome, and users had to take care not to send them through incompatible wallets. Some companies turned towards other blockchain applications, and the original protocols became largely historical projects.

The difficulty had never been simply marking a bitcoin as something else. The harder part was getting everyone to agree on what that mark meant and ensuring that it survived when the asset changed hands. Bitcoin could record the transaction, but the meaning of the asset depended on the rules built around it.

That problem did not disappear when Colored Coins faded. It followed digital assets into the systems that came afterwards.