The colored coins space is certainly heating up with leading start-up Colu raising $2.5 million from large investors such as Aleph, Spark Capital and BoxGroup.

The growth in the space has not been lacking in innovation. Start-ups such as Shocard, which aim to replace cumbersome bank processes to GetGems – a blockchain based social media platform are proof that new, out-of-the-box uses for the blockchain are yet being discovered by the day.

In a recent paper titled, “Watermarked tokens and pseudonymity on public blockchains”, Tim Swanson of R3 CEV highlighted the main pain points of using colored coins. According to the research, colored coins users will inevitably face immense scalability issues, the likes of which could be solved by constructing one’s own private blockchain.

However, for several bitcoin 2.0 start-ups hoping to push out an MVP and lacking the capital to build their own private blockchain, colored coins might be just a great first step to on-chain asset issuance.

To make more sense of the movement, here’s a quick explainer on “Colored Coins”:

1) What are Colored Coins?

Colored Coins (aka tokens) = Bitcoin + Color Layer.

Basically, the bitcoin is used as a transaction mechanism.

Later, a set of proprietary rules called “color kernels” is attached to the bitcoin by associating certain properties to it, making a “Colored Coin”.

2) How Do Colored Coins Work?

Colored coins were originally a hack to circumvent the public consensus rule of the blockchain network and enable off-chain asset issuance.

It functions by adding a 4th layer to the bitcoin blockchain.

The layers of the bitcoin blockchain are:

1st Layer: Network

2nd Layer: Consensus

3rd Layer: Transaction

4th Layer: Watermark (Color)

The watermark is created through proprietary code and executed through the use of UTXOs: Unspent Transaction Output, i.e. units of bitcoin that are tracked on the blockchain and are known to represent external value. E.g. Gold, Car Deeds.

This watermark enables a private key holder to pass an off-chain asset through the blockchain.

In a nutshell, the colored coin protocol enables the blockchain to go beyond simply tracking ledger entries for one specific on-chain asset (Bitcoin) to tracking several off-chain assets such as gold in our case.

3) Colored Coins Protocol Service Providers

The 3 main contenders are:

Colu

Coinprism

CoinSciences

4) Alternatives

The main alternatives to colored coins as a method to on-chain asset issuance are: