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Colored coins & tokens

By: Raffaella Lovati

What is a token?

Crypto tokens are assets created through initial coin offerings (ICO). The owners of these tokens have the right to claim the underlying asset, which may be any real assets, from a house to a commodity, from a fiat currency to a cryptocurrency. These crypto-assets often serve as units for transactions on the blockchain, which keeps track of all the movements of the token.

Usage Tokens vs Work Tokens

A Utility Token functions like a currency, having a monetary value. In this case, the token does not classify according to the Howey test as a security token. Utility tokens can:

- give holders a right to use the network,

- give holders a right to take advantage of the network by voting.

The most representative example is Golem. In fact, to use Golem’s services, it is necessary to pay with Golem Network Tokens.

Security tokens are crypto tokens that pass the Howey test, meaning that they satisfy the following requirements:

- they are an investment of money,

- they are an investment in a common enterprise,

- they have an expected profit from the work of the promoters or the third party.

As these criteria are met, tokens are classified as securities, from which security tokens. A security token identifies someone as a kind of shareholder in the blockchain. A clear example are the DAO tokens. To be the holder of a DAO token gives the right to vote on whether or not to give funding from the DAO (Decentralized Autonomous Organization).

Why do we need tokens?

Even if it is not evident, in real life, apps and places use instruments similar to tokens instead of cash. For instance, to enter into a cinema room or to buy good and beverages, it is needed to show the ticket. In this scenario, the ticket is a token.

Security tokens are particularly important because they concern assets that already exist in the real world, and indeed they are the connecting element between the world of finance and the blockchain world. The advantages of using security tokens could be to speed up the execution time, increase the number of investors, decrease costs of lawyers’ services, increase liquidity and, eventually, protect from manipulation.

Introduction to colored coins

Bitcoin is not just a currency, but a powerful protocol from which many technologies and implementations have followed. Each Bitcoin is made of 100,000,000 units, called satoshi and each satoshi can be the source of a special type of coin, called colored coin. A colored coin is a crypto token that is based on the Bitcoin blockchain. The users of colored coins recognize the ownership of the asset as represented by the unit of the Bitcoin, and this allows to use the decentralized consensus offered by the Bitcoin blockchain to guarantee secure transactions and to track the ownership of the asset.

Steps in the creation of a colored coin

The process of the creation of colored coins consists of three steps:

1. members of the blockchain interested in creating the coins agree to make a sub-unit of a bitcoin represent an asset,

2. the sub-unit quantity must be decided, so that at each quantity is associated the asset,

3. the transaction takes place via colored coins and are recorded on the Blockchain,

The resulting transaction is safely and transparently recorded on the blockchain.

Technical insight

The traceability of Bitcoin enables the creation of additional ledger on top of the Bitcoin ledger, where colored coins are built. Colored coins do not require the change of the Bitcoin code base and they function through the proof-of-work consensus mechanism of the Bitcoin ecosystem.

Application 1: IPO

Colored coins are more powerful instruments than what they seem. One of the most interesting possible implementations is for IPOs of companies. Instead of being listed in an exchange, a company could create and issue a colored coin for any share it wants to issue. This can potentially be revolutionary because, in the current environment, companies face several challenged. Firstly, small companies suffer valuation discounts as for them it is difficult to attract investors’ attention. Secondly, the process of getting listed is very costly, with strict regulations. Thirdly, blockchains are international and free from national boundaries, a significant advantage for companies that normally face big issues to be able to be listed in international exchanges. Finally, colored coins can positively affect investors as well. In fact, stock exchanges have increasingly sold collected data to third parties, creating misalignment of interest.

Application 2: car rental

Colored coins could be commonly used by any car rental company to ease the process of leasing. For instance, a car rental company could release a colored coin representative of the car and make configurations of the car to make it open, turn on or start some functionalities when the contract is bought. When the transaction happens, the car start executing operations if it receives a message signed with the private key that currently owns the colored coin.

Application 3: copyright

Not only merely physical assets can be used to back colored coins, but also intangibles. For instance, a colored coin could be made by the current ownership of a digital object, e.g. songs.

Ethereum Tokens

Colored coins are not the only possible example of tokens. As they use the Bitcoin blockchain, Ethereum Tokens use the Ethereum blockchain. Even in this case, this token can represent anything, from video games to real assets. The peculiarity and main difference with colored coins is that the Ethereum blockchain is structured to support decentralized application given to the advantage of the Ethereum token over other tokens, e.g. Ethereum supports smart contracts.

Application 1: Bancor (BNT)

Bancor gives its users the possibility of creating new cryptocurrencies using the Ethereum blockchain. The created Ethereum Tokens can be traded against reserve tokens.

Application 2: OmiseGO (OMG)

OmiseGO offers an international payment solution allowing merchants to accept payments through China’s ALIPAY. Any supported currency can be used to buy anywhere in the world. This allows users to avoid exchanging money and paying fees for that.

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