IOTA Digital Assets

This article is a translation of the German IOTA Beginner’s Guide by Schmucklos.

Digital Assets

What are Digital Assets?

IOTA Digital Assets (also called Colored Coins) are tokens that are based on IOTA and can be used to tamper-proof represent assets from the real world. Basically they remain “normal” IOTA tokens but in a certain context or in a specially created app they can mean different things and may have a higher value than the normal IOTA token. For a better understanding you can also imagine this as a kind of label, which is stuck to the token when sending it and identifies it as a special token. The regular IOTA token is only used as carrier. The term Colored Coin has also been established in the cryptoscene.

IOTA Colored Coins can only be based on value objects (smallest unit = 1 i), because you cannot own message objects (0-value). In a Colored Coin issuance transaction (Genesis transaction), the user can give his coin a self-selected name. Additionally all tokens of this transaction get a unique Color-ID as identification, which assigns a special meaning to all these tokens. The Color-ID and the Genesis Transaction-ID are identical. This ensures that the color code is unique and not reproducible.

Colored Coins never increase or decrease the specified max IOTA token supply. It is up to the merchants and other systems to give meaning to the Colored Coins. Because of the way the additional labeling (Color ID) works, any holder of Colored Coins can “shrink” the circulating amount of the asset again by simply creating a new issue with the original IOTA label. That is something to keep in mind when developing an app with Colored Coins.

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Key factors

  • The creation of Colored Coins is accomplished with a “one-time” transaction (Genesis) via the Firefly wallet
  • All tokens of this transaction get a unique Color-ID as identification. The name can be chosen freely
  • The Color-ID and the transaction-ID are identical. This ensures that the color code is unique and not reproducible.
  • The amount of Colored Coins created cannot be increased afterwards by further issues. This would only be possible via a Smart-Contract, which creates new Colored Coins, calculates the new number on the addresses and exchanges the old ones against the new Colored Coins.
  • With a new specified issue transaction, the originally created Colored Coins can be overwritten or deleted (original IOTA).
  • Colored Coins have no connection to the person who created (minted) the Colored Coin. The person who has access (seed) can overwrite these Colored Coins or restore them to their original state.
  • Colored Coins are application specific. This means to recognize Colored Coins as such, the application must know the used Colored Coin value object with the additional Color-ID, otherwise a normal IOTA token aka 1i will be recognized. Example: Let’s say in the computer game XY a Colored Coin based “Gold-Token” is used for buying items, this used “Gold-Token” is only recognized as such by this game. For all other applications / wallets it would remain a normal IOTA token.
  • For an automatic recognition of all Colored Coins, a database could be created in the future, in which all Colored Coins can be registered with purpose of use, etc.
  • Due to the game theory around Mana, a Colored Coin will not be able to compete with the regular IOTA token for a value transfer. A Colored Coin will generate too little Mana in the network (with 1i value) no matter what asset is mapped with it. Due to the Mana regulated transaction rate and the minimum Mana requirement of the nodes for transactions, a brisk trade without additional Mana with Colored Coins is prevented. A Colored Coin is therefore not suitable for a replacement of the regular IOTA token for value transfer.
  • Dust protection also applies to Colored Coins. A minimum of 1 Mi on an address applies (can also be regular IOTA tokens).

Use Cases

The following passages describe some, but by no means all, of the possible use cases for IOTA Colored Coins. It will be up to the community and industry to find more innovative ways to use the new features of the protocol.

Utility Token

A Utility Token provides a benefit to its owner by giving them access to goods, services, or products through the use of a token. A paper-based concert ticket, gift cards you collect at a coffee shop, or a monthly pass for public transportation are all examples of Utility Tokens. They can be used to prove that you actually have the right to use their services.

Colored coins can provide the same functionality in a secure, digital world with added benefits:

  • Tokens cannot be counterfeited.
  • Tokens are held in the user’s digital wallet. The IOTA Tangle provides a decentralized management framework to distribute, transfer and manage tokens.
  • Anyone can create, transfer or hold tokens in a permissionless manner.
  • Colored Coins inherit the feeless nature of IOTA. Transferring a Colored Coin has no cost.
  • Issuers must bear the cost of acquiring the IOTA tokens that are to be colored. At a current market price of $1.30 for 1 MIOTA (Feb. 17, 2021), an issuer must spend $1.30 to purchase IOTA coins to mint 1 million colored coins.
  • Utility tokens can be converted into regular IOTA tokens. This is beneficial in 2 ways:
  • Once users exchange the utility tokens for a service, the service provider can easily convert the tokens to IOTA or re-ink them to use for another service.
  • Users holding the utility tokens can also convert them to IOTA at any time, although this is only rational behavior if the face value of the utility tokens in IOTA is higher than the service for which they can be redeemed.
  • Utility tokens can be easily integrated into the Firefly wallet.
  • The issuer can easily monitor the distribution, usage, and available supply of the Utility Token by examining the IOTA Tangle.

In summary, Utility Tokens on IOTA provide a secure, convenient, and inexpensive way to sell services, organize loyalty programs, and digitize paper-based token systems.

Security Token

Security tokens refer to digital tokens that are financial assets that fall under the category of securities. They are tradable financial instruments that are highly regulated, with conditions varying depending on the issuer’s country.

There is huge potential in the security token industry as they address the shortcomings of traditional securities:

  • Regulatory compliance (KYC, AML, etc.) can be enforced through the underlying protocol.
  • Both regulators and issuers have real-time data on how securities are allocated and traded in the market.
  • Traditionally illiquid assets such as real estate or art can be tokenized, allowing for better price discovery, fractional ownership, and more liquidity.
  • The cost of managing securities drops dramatically as the token can act as a management entity.
  • A security token can be traded on secondary markets around the clock.
  • Security tokens can lower the barriers to entry for smaller or retail investors.
  • It is important to note that a Security Token itself is only a claim on the underlying security. It is not the asset itself.

One of the biggest technological challenges of security token frameworks built on distributed ledgers is how to enforce compliance. Smart Contract platforms are well suited to solve this problem by using autonomous agents (Smart Contracts) at the base layer to manage the security token lifecycle.

IOTA has its Smart Contract solution (ISCP) at the 2nd-layer because the base layer of the IOTA protocol must remain lightweight enough to meet the needs of the machine economy. ISCP lends itself to advanced security tokenization, where all the properties of a security token can be programmed and enforced by the Smart Contract itself. An issuer can control supply, regulate trading, or even reverse transactions if required by law. Of course, this is not possible on the base layer, as it would add too much complexity to the protocol.

However, there is another way to perform lawful Security Tokenization on base layer, using Colored Coins. An issuer could mint Security Tokens as Colored Coins and distribute them to multi-party signature addresses.

  • To release funds, both the issuer and the user must sign the transaction.
  • Transfers to addresses that are not verified would not capture the issuer’s signature.
  • The issuer can stop the trade and enforce compliance rules because it knows the verified identities of the users.
  • The security tokens are still managed in a secure, decentralized and feeless infrastructure, the IOTA Tangle.

In summary, Colored Coins provide the opportunity for security tokenization at the base layer with trusted issuer platforms, but also enable Layer 2 solutions such as ISCP that implement fully customizable, self-enforcing rules as autonomous agents.

Non-Fungible Tokens

Digital tokens can be divided into two categories based on their type of fungibility:

  • Fungible tokens are interchangeable with other tokens of the same type because they represent the same value. Cash or IOTA is fungible because one $10 bill can be exchanged for two $5 bills, and 10 MIOTA is equivalent to 5 MIOTA + 5 MIOTA.
  • Non-fungible tokens, on the other hand, are not exchangeable because each token has unique properties that give it its value.

A Non-fungible Token (NFT) can represent a work of art, a collectible, or a special edition. It is essentially a digital property right that can be traded. Some exciting use cases include:

  • Crypto collectibles like crypto kittens, fantasy football league cards, etc.
  • In-game items that can be traded on secondary markets.
  • Digital artwork that is recorded in the ledger.
  • NFTs can also be used as collateral in decentralized finance.
  • Event tickets: NFTs can add great value and transform traditional ticketing to smart ticketing. As NFTs, smart tickets are verifiable, interoperable and have clear ownership. Therefore transparent secondary markets are also possible without the buyer having to fear fraud. If reselling a ticket is strictly prohibited (e.g., personalized tickets), the organizer can enforce this without any problems. NFTs can be coded non-transferable and therefore prevent ticket transfers. In addition, ticketing companies can save quite a bit of money because the cost of minting smart tickets is negligible, especially compared to traditional ticketing infrastructure. Properly structured, hundreds or even thousands of NFTs (smart tickets) could be created for less than a few euros. Another aspect of NFT based smart tickets is after it is redeemed at an event, the ticket does not die. It continues to live in the user’s wallet and can be collected, traded or whatever if necessary.

Support for Colored Coins in the IOTA protocol would finally provide the ability to create NFTs at base layer. A color is a globally unique property of a minted token. So if only one token is minted with that particular color, it becomes an NFT. Of course, it is fungible in the sense that it can be uncolored and used as a normal IOTA token, but no other coin can be created with the same color. So it is a true NFT until the owner decides to destroy it.

A NFT can also be considered a “global identity token” that can have data attached to it. By attaching metadata to the NFT’s base layer transmissions, a nonforkable (non-copyable) chain of data states can be established. Therefore, it is perfect for use cases such as IOTA Access, IOTA Streams or IOTA Identity.

The nonforgeable property of a single Colored Coin at base layer is essential for building ISCP at Layer 2:

  • A Smart Contract chain could be identified by the account holding the unique NFT of the contract chain. It is minted when the chain is deployed and can be destroyed when the chain dies.
  • Smart contracts need a way to automatically process (user) requests at base layer. A Smart Contract chain must have a way to manage currently pending and completed requests. This is what we call the backlog of the Smart Contract chain. The idea is to mint a unique Colored Coin for each request and transfer it to the contract chain’s account. After the request is completed, its NFT can be destroyed with the state anchor transaction that settled the request.

It is important to note that a Colored Coin used as an NFT has only one property: its color. Therefore, advanced use cases where a variety of unique properties need to be associated with a single token are not supported at base layer, but are supported at Layer 2 via ISCP. However, if the NFT represents a property right, the original attributes of the property could still be stored outside the Tangle, in a Distributed Registry or in a Registry Smart Contract.

Colored Coins are more than just tokenization

IOTA Digital Assets are more than just a competitor to ERC-20 tokens and the ability to tokenize things in the IOTA protocol. They are much more important because they enable “consensus over data.”

By creating a single, unique digital asset that you can spend on yourself over and over again, you can create a chain of issues backed by consensus. When you submit data with these outputs, everyone on the network will not only agree on the order of the published data, but will even agree on which data to use when conflicting information is published. This is incredibly important for various use cases beyond tokenization.

IOTA Smart Contracts will heavily leverage this capability to build “private, non-counterfeitable blockchains” that can only be updated by the digital asset owner. However, Smart Contracts are also just one example of a variety of use cases that require consensus on data and its order. There are many more, such as Oracle, digital twins, and the DID protocol.

Notes, problems, risks, regulation

  • Dust protection refers to preventing unnecessary enlargement of the ledger database by splitting funds into multiple, smaller issues. In Chrysalis Phase 2, a new Dust protection mechanism was introduced that defines at the protocol level when such small issues can be accepted. Dust protection does not change with the introduction of Colored Coins. A SigLockedColoredOutput is considered Dust if it has an amount that is less than 1 Mi.
  • Although a Colored Coin is secured on transmission according to the same rules as a normal token Colored Coins differ significantly from normal tokens because they represent real physical assets and financial obligations. 
  • Any digital asset issued by a person or organization represents an additional risk. There will always be a possibility that the issuer of the digital asset may fail to meet its inherent obligation. There is even a risk that they do not represent anything real and are completely fraudulent. 
  • Because of these risks rules and regulations will inevitably be needed to fully exploit the potential of this technology. In Germany corresponding legislative changes have already been initiated since the end of 2019. With these draft laws, token assets will become financial instruments and will be subject to financial market regulation. BaFin has also already taken a position on this topic.

Conclusion

Users will need to purchase IOTA tokens if they want to use digital assets on the tangle. The implementation of digital assets will lead to a shortage in the supply of regular IOTA tokens and, as a result, increase the demand for the IOTA token.

For example, an ICO on IOTA would reduce the current amount of IOTA tokens as opposed to an ICO on Ethereum where ERC20 tokens are created out of thin air.

While IOTA tokens are used throughout the tangle, digital assets can only be used where they are recognized and accepted by a special app. Normal nodes and wallets will not recognize digital assets.

Through the multitude of new applications, digital assets strengthen the IOTA ecosystem. In my opinion, only coins / tokens that have a strong ecosystem of their own and offer a variety of different ways of use will survive in the future. The larger and more extensive the ecosystem, the more often the token is used, the scarcer the supply and the higher the price.

I am curious to see which use cases we will see in the future.

More Details

Tokenization on the Tangle with IOTA Digital Assets – IF

Original source

https://iota-einsteiger-guide.de/iota-digital-assets.html

Last Updated on 23. March 2021