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What are Colored Coins?

Attorney Brock Cusick explains why a Bitcoin could be “colored.” The colored coins concept remains nascent but benefits, risks, and regulatory implications are already coming into view.

Colored coins are bitcoins (or more probably, the smallest measurable fraction of a bitcoin called a ‘satoshi’) that have been ‘colored’ in order to represent another asset, such a share in a company, a US Treasury bond, one US cent, a derivative, a car loan, or a fraction of a collateralized debt portfolio. To understand how this works and what the implications are it’s first necessary to understand what Bitcoin really is (it’s not just ‘digital gold’) and how it works.

What is Bitcoin?

Bitcoin is a new software technology invented by a pseudonymous developer who went by the name Satoshi Nakamoto. We don’t know who Nakamoto is in real life, but as Bitcoin is open source software that thousands of other programmers have reviewed and verified, it doesn’t really matter who he was. Explaining what Bitcoin is and how it works is sort of tricky however because it has no direct historical analogue; any simple analogy will always fall short in conveying understanding. Therefore I hope you will bear with this explanation.

Bitcoin is an open digital protocol for exchanging certain kinds of messages across the Internet, the same way that Hypertext Transfer Protocol (HTTP) is a protocol for transmitting web pages and Simple Mail Transfer Protocol (SMTP) is a protocol for sending email. The Bitcoin protocol was initially described by Nakamoto in 20093, and all software implementations of Bitcoin today (of which there are several) adhere to this protocol, though in a slightly evolved state since then.

The purpose of the Bitcoin protocol is to allow a network of computers, operated by users who are unknown to each other, connecting over the Internet, to cooperatively maintain and verify the accuracy of a shared database called a “blockchain”. The blockchain itself can be thought of as a ledger, such a bank or stock exchange might maintain, which tracks the ownership of “bitcoins”, a digital unit which exists solely on the Bitcoin blockchain.

Each bitcoin (note the lower-case ‘b’. ‘bitcoins’ means the currency, while capitalized ‘Bitcoin’ means the protocol) is usefully thought of as a bearer certificate with a series of endorsements on it noting any changes in the bitcoin’s ownership from its original minting by the Bitcoin network of computers to the present day. When a user of the Bitcoin software wishes to convey his bitcoins to a new owner, the conveyor digitally signs the bitcoin, much like you would endorse a check, and the receiver of the bitcoin then also signs the bitcoin in such a way that the network can recognize his signature (and no one else’s) later when he wishes to convey the bitcoins to someone else in turn. In this way, ownership of bitcoins can be transferred over the Internet, from one computer or mobile device to another, without going through a financial intermediary such a bank or traditional money transmitter business.

So to recap, Bitcoin is an open source protocol and software package for maintaining the blockchain, a global distributed ledger of transactions in and the current ownership of bitcoins.

Double-Spending and Market Prices

Ultimately bitcoins are just digital files, like a Word document or MP3 music file. Like any other digital file, you can make copies of it. If I conveyed a bitcoin to you, you could make millions of copies of that file.

But does that mean you could copy and paste your way to riches by making millions of new bitcoins? No, it does not. Each bitcoin has a unique identifier, and the blockchain, maintained by the global network of computers running the Bitcoin software, will only recognize the most recent valid version of that particular bitcoin which the network is aware of. If you did have millions of copies of a bitcoin on your computer, but you then conveyed any one of them to another person over the Bitcoin network, it would have the effect of rendering all the copies worthless because the Bitcoin network would no longer recognize them as the most recent valid version of that unique bitcoin.

Bitcoins thus cannot be “double spent”. Once conveyed to another person, and that conveyance is validated by the global Bitcoin network, the original conveyor cannot convey the same bitcoin to again anyone else. It is provably owned by the receiver.

This ability to prevent double-spending and verify ownership of bitcoins is the foundation for supporting colored coins. The Bitcoin network provides similar safeguards against double-spending or forgery as currently found on the New York Stock Exchange or in the physical nature of assets like gold.

How are Bitcoins Colored?

Another useful analogy might be to think of all the bitcoins currently existing as millions of identical blank pieces of paper. The Bitcoin network makes this paper as a part of its ongoing work, but initially they are all blank. Each bitcoin is an identical blank piece of paper, standing only for itself. Any attempt to write on the paper prior to April 19, 2014 resulted in a “dead” bitcoin. The Bitcoin network would cease to recognize it and transfer to another person became impossible.

On April 29, 2014 however the Bitcoin software was updated to version 0.9 and a new feature was added called OP_RETURN. The exact technical workings of that function are beyond the scope of this paper, but the effect is that now the pieces of paper can be written on without making them unspendable. You can write “This is a Class A share of General Motors” or “This is an IOU for $200 issued by James Smith of Cleveland, OH” on a bitcoin, and (assuming all parties are using the correct software) transfer this new asset to someone over the Bitcoin network.

The Potential of Colored Coins

As a software technology that runs on the Internet, bitcoins are transferrable to any computer, tablet, or smartphone, anywhere in the world, as easily as sending an email or text message. They are transferred in a peer-to-peer fashion directly from seller to buyer without going through any intermediary. This is true for colored coins as well, which should make the potential uses for colored coins start to become apparent.

Imagine any financial instrument you may be familiar with, from common stock, to money market shares, to credit default swap derivatives. Those instruments are currently issued by companies or banks onto central exchanges such as the New York Stock Exchange, or they are traded over the counter between sophisticated institutions. With colored coins the possibility exists that these issuers could list the instrument on the Bitcoin network instead, and sell them to anyone, anywhere in the world, who has access to an ordinary PC or even smartphone.

Furthermore, because issuing colored coins is something that can be done on a home computer for very minimal fees (like $1 or less), it’s possible that many assets which are not currently traded could become so. A simple example be an IOU issued by an independent electrician somewhere in Wisconsin looking to raise funds to buy better tools, or shares in a young girl’s lemonade stand.

Now combine the thoughts contained in the three previous paragraphs. The true potential of colored coins is that any business or individual, anywhere in the world, will have access to globalized capital markets. A small factory in Uganda could find investors in Germany or Japan. A new business in Minnesota could attract investment from China or California. A musician in Brisbane could fund studio time and hire recording professionals with the help of his fans. 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.

Risks

Of course, colored coins will not be without risks. Colored coins are maintained and traded over the Bitcoin network, but they are different from ordinary bitcoins in that they represent something that exists outside of the Bitcoin network, such as a share in a company or an obligation to repay a debt. Colored coins are thus inevitably issued by a person or company, and this means they always carry with them the risk that the issuer will fail to perform in some fashion or otherwise not honor the obligations associated with the colored coin. Or they may not actually represent anything real at all, and just be frauds.

Regulators should absolutely be aware of this risk, but should also approach the risk with an open mind. Just as email has brought all of us the opportunity to assist Nigerian princes with moving funds overseas, colored coins will no doubt offer us the opportunity to invest in non-existent oil wells or Russian diamond mines long since played out. Email scams are something that every American has come to recognize, and with proper education they will learn the risks of colored coins as well – while still using the technology for its intended purpose, to the benefit of all.

The Current State of Colored Coins

The current state of colored coins is immature, as should be expected of a technology invented so recently. There is no market on Bitcoin for US Treasuries or shares in Google. Anything like that is merely a potential future. Currently there are only a few ‘wallets’ (pieces of software used to store and transfer bitcoins) that support colored coins, and only one or two websites where technologists have begun experimenting with issuing coins among themselves. There is a fair amount of time and needful technological development between now and the future described above.

Brock Cusick is an attorney at Deutsche Bank AG. The views shared here don’t necessarily represent Deutsche Bank’s positions, strategies or opinions.

Based in Washington, D.C., Coin Center is the leading non-profit research and advocacy center focused on the public policy issues facing cryptocurrency and decentralized computing technologies like Bitcoin and Ethereum. Our mission is to build a better understanding of these technologies and to promote a regulatory climate that preserves the freedom to innovate using permisionless blockchain technologies.