What are Colored Coins?

Colored Coins: 

Due to the nature of the Bitcoin blockchain, bitcoins are not inherently fungible: every single coin mined can be uniquely identified and its entire history tracked. The smallest identifiable, indivisible, unit is known as a “satoshi.” A single “bitcoin” is a collection of 100,000,000 satoshis; thus the price of a satoshi is very low: about $0.0000026 at current market rates.

This lack of fungibility, though potentially problematic, opens the door to the implementation of ledgers on top of the Bitcoin ledger. If several parties agree to attach meaning to a particular satoshi and to recognize its control as representative of the ownership of some other asset — potentially existing outside of the blockchain — then they can use the decentralized consensus offered by the Bitcoin blockchain to track ownership of the asset and permit secure transactions. The antecedent is crucial. The asset can only be tracked on the blockchain insofar as its physical custodians, or the relevant authorities, agree to recognize the legitimacy of the colored coin. The mere technological ability to track an asset, from common stocks to parcels of land, does not magically translate into the ability to form an authoritative record of ownership. All too often is that obvious fact sacrificed upon the altar of hype.

Assuming such an agreement is in place, these tiny, identifiable, pieces of bitcoin can be used to represent and track assets. Such a coin is known as a “colored coin.” In addition to the ownership tracking abilities inherited from the Bitcoin blockchain, small amounts of data can be embedded in the blockchain, allowing for potentially more complex mechanisms.

Read the full article by ArthurB:
"Making Sense of Colored Coins"