Bitcoin is a useful way to exchange money, but what if you could do other things with it? If bitcoiners could use it to issue shares, bonds and IOUs, or even to create alternative currencies atop bitcoins, they could add even more value to this innovative cryptocurrency. Bitcoinx, a community wanting to “democratize finance,” is hoping to facilitate just that, with a concept called “colored coins”.

Colored coins is a concept designed to be layered on top of Bitcoin, creating a new set of information about coins being exchanged. Using colored coins, bitcoins could be “colored” with specific attributes. This effectively turns them into tokens, which can be used to represent anything.

“It’s a distributed asset management infrastructure that leverages the Bitcoin infrastructure, allowing individuals and companies to issue various asset classes,” says Ron Gross, an Israeli programmer and active member of the bitcoin community, who was involved in the early stages of the colored coins project.

“The issued assets can then be traded between users without relying on a central authority. All the relevant advantages of Bitcoin apply (your account cannot be frozen, no middleman, cheap transactions).”

In a whitepaper (still in progress) on the subject, another contributor, Meni Rosenfeld, describes a variety of applications. Colored coins can be used to represent physical assets, such as a house or car. They could stand in for financial instruments such as stocks or bonds, or even interest-bearing assets. How about an IOU? Smartcoins open the way for credit infrastructures built on Bitcoin.

There are challenges for colored coins, however. One came in the form of a patch to the Bitcoin protocol, announced in early April. The “anti-dust” patch, as it has become known, imposed a minimum size on any output in a bitcoin transaction. An output is a unit in a bitcoin transaction that defines the new owner, and the amount of bitcoins that he or she receives. In the new setup, any amount fewer than 5,430 satoshis (0.0000543 bitcoins) is disregarded. The developers made this patch to stop people from stuffing the blockchain with lots of microscopic transactions.

While 5,430 satoshis may seem small, colored coins works best with far more granular transactions than this. The patch was a setback for the project. “Colored coins can still work more-or-less fine even with these drawbacks, but now people say we should redesign (the) coloring scheme,” says Alex Mizrahi, who heads the colored coins project. “There are several proposals, but this is just a major slowdown.”

What would it take to get the Bitcoin community using colored coins? Much depends on whether we’re talking about native support at the protocol level, or add-on, “floating” support in bitcoin clients.

Native support will help with the performance of thin clients (client-server versions that don’t store entire copies of the blockchain), says Mizrahi. “I believe it is very unlikely. Bitcoin does not welcome new features, from what I can tell.”

He expects native colored coin support in an altcurrency before bitcoin. However, the major Scrypt-based currencies aren’t looking at it. “We may look into providing some color coin implementation directly in the Litecoin protocol, but nothing is planned right now,“ said Litecoin creator Charles Lee.

Neither is Feathercoin, another Scrypt-based altcoin based on Litecoin. Founder Peter Bushnell said that he has his hands busy at the moment, after fending off a massive 51-percent attack earlier in June. “We are busy enough right now and find ourselves at a crossroads. This is the sort of thing I would like to look into at some point later on,” he says.

But the creator of another SHA-256 currency – Freicoin – is very interested in a variation on colored coins. It is perhaps no wonder that Mark Friedenbach is enthusiastic about the idea. After all, he wants to rewrite the rules of usury with his currency.

Building a colored coins technology that is binary-compatible with Bitcoin will be problematic, he asserts, because of what he describes as high transaction fees. “We came up with a proposal that achieves everything that people want from colored coins. We will implement those on Freicoin, and then let Freicoin be basically the medium for exchanging credit and IOUs in the same way that Bitcoin is for exchanging hard cash.”

He says that the specification is almost finished, and that he is working to get it peer reviewed. “As soon as we deploy Freicoin assets, we’ll be hitting the scaling of Bitcoin,” says Friedenbach. He’d better prepare himself, then, as he wants his version of colored coins – called Freicoin Assets – out by Christmas.

But Bitcoin could see its own implementation in the form of a floating set of specifications that can be implemented in third-party bitcoin clients, rather than in the protocol itself. The good news is that, unlike some other services such as anonymity, colored coins don’t explicitly need integrating into the protocol, says Tamás Blummer, CEO of Bits Of Proof. His company produces an open-source, enterprise-class Bitcoin server that he says can already propagate colored coins.

“Colored coins is a logical layer above the core Bitcoin protocol,” says Blummer. “I believe that it should not need changes, only extensions.” He aims to have a color-aware wallet by the autumn, and says that a supporting infrastructure for transactions could be reality by the end of the year.

In fact, clients are already available. Mizrahi and his colleagues produced a version of the Armory client capable of handling P2P colored coin transactions in January of this year. Then, realizing that colored coins added a processing burden to an already resource-hungry client, he produced a web-based client instead: WebcoinX.

Part of the problem with implementing colored coins, says Mizrahi, is getting developers to work on it. Gross agrees. “Unlike Bitcoin, a clear path to monetize the colored coin infrastructure hasn’t emerged yet. So, there is relatively little incentive for people for work on colored coin projects,” he says. “As a result, Ripple.com, a direct competitor, has gained significant market share. Ripple.com solves very similar problems to colored coins.”

Like colored coins, Ripple is designed to facilitate credit structures in the world of math-based currencies. But Ripple is based on its own currency, XRP, and is also still currently controlled by a holding company, putting it in direct opposition to the decentralized ethos underpinning Bitcoin.

There are other issues. Any credit-based mechanism in colored coins would have to involve an element of trust. In colored coins, the trust would have to happen “out of band,” using a separate system.

“I believe we’ll see some infrastructure around it. Something like rating agencies, which will audit companies that issue stocks, bonds and currencies based on colored coins,” says Mizrahi. Such third-party systems would verify assets.

“Of course, it is completely decentralized, and potentially such agencies will compete with each other. We are going to offer some support for this on an ‘asset-definition’ level,” he says.

Ratings agencies? Stocks? Bonds? Futures trading? All of this begins to sound suspiciously regulatory, doesn’t it? The Bitcoin community is still in a world of pain thanks to regulatory tensions over issues such as whether an exchange is a money services business. Now, bitcoinX is proposing a decentralized way to create complex financial instruments while dispensing with those pesky anti-money laundering (AML) and know-your-client (KYC) rules.

If colored coins enable people to trade bitcoins as a placeholder for anything, they could land us in a world of trouble with already nervous governments. When bitcoins and stock trading have mixed in the past, things haven’t gone well. Remember the Global Bitcoin Stock Exchange?

“Tensions are unavoidable and will be even more severe here,” agrees Blummer. “I believe that Bitcoin has to work itself up the food chain, first targeting areas like crowd-funding before we attempt to ‘attack’ clearinghouses of stocks.”

Colored coins have a long way to go, but there is significant interest in making this work. David Johnston, the executive director of altcurrency investment network BitAngels, is interested in the concept.

The will and the technology is there. If Bitcoin is to get beyond the mundanities of mining, and turn into something more sophisticated, it needs this. The question is, who will use it first? As Blummer says: “Bitcoin is cash. With colored coin, you get the rest.”