Colored coins can be created to repurpose Bitcoin or altcoins (alternatives to Bitcoin) to create digital assets that represent other things of value.
Colored coins began as an improvised creation of Bitcoin miners. Data space in the blockchain had been used to encode various metadata values. This unexpected data created problems in processing, slowing down the network. Bitcoin's team corrected the issue by adding a 40-byte field where data could be stored as a transaction, along with the encrypted ledger of transactions and data about the coin’s creation.
This metadata makes it possible to repurpose the original cryptocurrency, which is typically done to represent something of greater value than the denomination of Bitcoin. This means that a data-based coin in a digital wallet can be used as a backing for a contract or a certificate for redemption. That use benefits from the coin’s security and verifiability of ownership, as well as the convenience of digital transactions. Some examples of things a colored coin may be repurposed to represent include amounts of gold in game currency or shares in a company. They could also be used to create a currency within a currency.
Colored coins are generally kept in special digital wallets. Much like cryptocoins themselves, the color is generally not a real-world quality; the metaphorical coloring is the addition of metadata.
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