How do coloured coins (or colored coins) work?

“Coloured”* does not refer to the aesthetics of Bitcoin (although it sounds pretty), but to the information that colours* transmit. We colour-code labels: a yellow sticker means file right away, a green sticker means read as soon as possible. We underline in red phrases that need correcting, in blue phrases that generate a comment. Colour can itself be an efficient code for more information, easy to learn and to understand.

colored stickers

The same principle applies to coloured coins. By “coloured”, we mean “labelled with additional code”. And this humble piece of additional code can extend the use of Bitcoin beyond what we can imagine today, and change the way we transact and do business. Before we go into the how, a brief look at some technical stuff:

The structure of the Bitcoin program allows each transaction to insert some “metadata**”. So if we want to add some “colour”, all we need to do is to spend a fraction of a bitcoin and add some metadata to that transaction. That converts it into a “coloured coin”, which still functions as Bitcoin, in that it is validated by the nodes, incorporated into a block and added to the blockchain. Like normal bitcoins, coloured coins are verifiable, non-changeable and transparent. But they can do so much more than just pay for something.

Some examples of coloured coins are:

  • Shares in a company
  • Tickets to gain admission to an event
  • Car ownership
  • Deeds to real estate
  • Ownership of domain names

Coloured coins add a huge amount of flexibility and versatility to Bitcoin, enabling it to act as a transmitter of non-monetary value, as a verifier of fact, as a time-stamper, as many other things, some of which we haven’t even thought of yet. Each coloured coin transaction, though, does require a small amount of bitcoin to be processed, which is never spent. So if this use for Bitcoin takes off, and it’s likely that it will, the amount of unspent bitcoins will grow, and we’re not yet sure what the effect of that will be.

Also, coloured coins can’t function with all wallets. You wallet needs to be “coloured coin aware” to avoid losing or corrupting the attached information. Some of the main desktop wallets that can handle coloured coins are Coinprism and Copay, with ChromaWallet still in development. Each can also issue coloured coins, but those coins will not be compatible with the other coloured coin wallet. That’s a bit messy, and could be a barrier to extensive coloured coin adoption.

And just in case you weren’t confused yet, coins can have more than one colour.

The concept is actually not as confusing as it sounds. It’s simply an instruction as to how to treat that transaction. With no colour/instruction, it’s a simple transfer of bitcoins. With a colour/instruction, it’s a transfer of bitcoins (usually the minimum amount) plus some other type of transaction.

* Big-time spelling confusion: I’m English, so coloured for me has a “u” in it. But across the ocean they’re called “colored coins”. This should be fun.

** If you’re curious about the difference between “metadata” and “data”, metadata is data about data. So why are we not just inserting “data” into the transaction? Because what you’re really inserting is a link to that data, or a hash (condensed encryption) of that data, not the data itself. There is a low cap (40 Bytes, or approximately 40 characters) on the size of the information that can be inserted, so a hash is more efficient and gives much more flexibility. Technically, it is data about data. And, metadata sounds cooler.

(For more on how Bitcoin works, see Bitcoin Basics.)

Are bitcoins fungible?

Two things are fungible if they are indistinguishable in terms of value from each other. They are completely interchangeable, and mutually replaceable. Fungibility is a basic requirement for any currency. One dollar has the same value as another dollar, one euro can be substituted for another euro. While it’s possible that you could get attached to a certain dollar because it has a special scribble on it, that attachment technically makes the dollar worthless. Or it could be worth even more, depending on who did the scribbling. What monetary value does a dollar have if you’re not willing to part with it? Even if the monetary value is higher than the face value, it technically is no longer a dollar, but a collectors’ item. So, for a currency to have monetary value, it needs to be fungible.

Are bitcoins fungible?

No, not really. Each bitcoin has a history associated with it, a log of all previous transactions, that anyone can see on the public ledger (it’s not easy to understand, lots of hashes and codes, but it’s there if you want to take a look).

bitcoin transaction

Since it’s very unlikely that any two histories are the same, this makes each bitcoin unique. And it’s possible that I really like the history behind my bitcoin, so I’m not willing to trade it for the less interesting history of your bitcoin. This means that the two bitcoins are technically not fungible.

Yet Bitcoin works as a currency, even though each bitcoin is different from the others. This is a very unusual property for a currency to have. And it can be used to make Bitcoin even more powerful.

When you scribble on a dollar bill, you are effectively adding additional information to that item. It is no longer just a dollar bill, it is a dollar bill with an additional message. We can do the same thing to bitcoins.

We can add to any bitcoin some additional information, or “metadata”, that helps it to function as something other than currency, such as a smart contract, or a time validation. This vastly increases Bitcoin’s value and broadens the technology into other fields. One of the most common ways of doing this is through coloured coins (more on these later), which add functionality while retaining all of Bitcoin’s advantages. The potential is colourful. (Sorry.)

(For more on how Bitcoin works, see Bitcoin Basics.)