Since its 2009 creation, Bitcoin has taken the world by storm. Bitcoin’s soaring popularity can be traced to several factors, including its simplicity and convenience as a reliable payment system. With Bitcoin, you can make fast, easy, secure peer-to-peer payments, and it is decentralized. The decentralized nature of the network allows for greater transparency and increased trust.
Bitcoin uses blockchain as a ledger to record all of the network transactions on-chain. It uses numerous nodes rather than a single centralized server, and each transaction is verified, recorded and distributed across the various nodes. Because there are no regulatory bodies or cumbersome paperwork involved, overhead is reduced, and so is the risk of errors.
The picture is not completely rosy, however. Security comes with trade-offs, in particular, the fees associated with the transaction, as it can mount during periods of network congestion. Processing speed can also grind to an unbearably slow rate during congested periods. Taking certain transactions off the blockchain might just simplify, speed and lower the cost of your Bitcoin transactions.
This begs the question: will off-chain transactions be the ultimate solution? And what are some of the drawbacks? Before we begin, let’s understand how does a distributed ledger work.
Blockchain’s Distributed Ledger Explained
A blockchain is a type of distributed ledger that records, shares and synchronizes transactions in a shared electronic database. First described in 1991, blockchain technology was designed to record transactions without the possibility of timestamp tampering. When Bitcoin was launched in 2009, it incorporated blockchain technology.
In a distributed ledger, independent computers called nodes record and track transactions and other data in their respective electronic ledgers, as opposed to a centralized data repository, such as a traditional bank’s ledger. Data is organized in blocks, which are chained together to create a blockchain. In which, allows anyone to view the entire history of the transaction and prove that there’s no double-spending of the coin. The resulting ledger can then be distributed across the various nodes that make up the blockchain network.
Distributed ledgers offer several benefits over conventional databases. First, they eliminate the need for third-party oversight, which is what makes them so appealing for cryptocurrency. For example, a proof-of-work blockchain provides an objective way for the nodes to validate the order of the transactions. Users can save considerable time, effort and blockchain transaction fees by skipping the intermediary and recording their transactions directly to the blockchain.
The decentralized nature of distributed ledgers makes them naturally secure. External attackers will find it difficult or even impossible to access them. The data they contain is highly transparent and spread across all nodes, freely available and easy to view. This transparency and accessibility make them popular not only with cryptocurrencies such as Bitcoin but in other industries as well.
Finally, distributed ledgers are tamperproof and immutable as well. No single user can alter the data they contain, which offers an additional layer of security for all users.
What Are On-Chain Transactions?
Bitcoin on-chain transactions are validated by miners and recorded on the blockchain. Once the transactions are added to the ledger, the blockchain network is updated and distributed.
A transaction must go through several steps before it can get into the blockchain. In order to carry out an on-chain transaction, you must own Bitcoin on the blockchain and it must be locked in an address. A private key is used to send your Bitcoin to a recipient’s address. Any user who carries out an on-chain transaction needs to pay a transaction fee that varies based on the transaction size of the in bytes and the amount of network traffic at the time. Network congestion can delay transaction processing, and a Bitcoin transaction with a higher fee is normally prioritized and confirmed more quickly.
The Bitcoin network is secure and reliable due to its transparency. Since the blockchain is open and the public ledger is readily accessible to all network participants, counterfeit or double-spending attacks are unlikely to happen. Security is ensured through blockchain immutability. Nothing can be changed, including transaction details, timestamps or other data contained in the blocks. Potentially malicious attacks are blocked before they can occur.
The Drawbacks of Bitcoin On-Chain Transactions
On-chain transactions offer many benefits when it comes to security, but there are limitations involving the blockchain’s scalability, speed and cost.
Scalability has been an issue plaguing Bitcoin nearly from its inception. With the ability to process only about seven Transactions per second (TPS) is the number of transactions a blockchain network can process each second or the number o..., the Bitcoin system can be cumbersome and pricey. For this reason, many users tend to keep their lower-value transactions off-chain to reduce network congestion.
Network congestion can lead to delays. On-chain transactions can be slow to confirm, and accepting an unconfirmed transaction comes with risks. For example, Bitcoin transactions are confirmed with an average of ten minutes though it could take up to an hour depending on the network’s condition. An off-chain transaction can be recorded immediately, eliminating the risk of reversal.
Finally, fees are a necessary part of doing business both on and off the blockchain. Miners charge fees for confirming transactions. Unfortunately, these fees can rise sharply as network congestion increases, resulting in higher transaction costs.
Understanding State Channels
State channels allow users to complete Bitcoin transactions directly off the blockchain and minimize the use of on-chain operations. This alternative uses smart contracts, which define the rules under which an off-chain transaction can occur. Each off-chain transaction creates new states and must be signed by the respective parties. The new state invalidates any previous states.
To use a state channel, each party must open a channel transaction and deposit the appropriate amount of currency. Parties can then begin to make off-chain transactions using the channel, and the smart contract ensures there is no double-spending. The combined transactions will equal the total amount of deposited currency. When the channel is closed, the final tally is added to the blockchain.
How Do Off-Chain Transactions Work?
Off-chain transactions are any transactions processed outside the blockchain. These second-layer protocols aim to circumvent the on-chain’s flaws by enabling a cheaper and faster transaction.
Users can open a channel and exchange private keys to that wallet, which enables fund transfers off-chain. As long as the channel is active, they can then continue to swap currency as much as they want until they’re ready to settle, at which point they can close the channel and record the final tally on-chain.
Unlike on-chain networks, there are plenty of off-chain protocols. These include the Lightning Network, Liquid Network, and more. Let’s dive into it.
The Lightning Network is a Layer 2 protocol built on top of Bitcoin’s blockchain that allows users to engage in limitless transactions instantly and for minimal cost. The Lightning Network also allows for cross-chain atomic swaps, offering even greater convenience and versatility without the need for third-party custodians.
It is a decentralized peer-to-peer network, which means participants can transact by locking up their Bitcoin in a multi-signature address using a funding transaction. Participants can perform infinite transactions repeatedly with the address for off-chain transactions until the balances are finalized on the blockchain.
The Liquid Network is a sidechain protocol, meaning it relies on the Bitcoin blockchain for the data, but the operations are carried out separately. Like the Lightning Network, it’s built on top of the Bitcoin blockchain and enables users to transact off-chain while still enjoying security and privacy. The Liquid Network is faster than the main blockchain and more affordable, and it’s confidential, which means that it doesn’t reveal the amount of currency involved in a specific transaction. The only downside is that Liquid is not decentralized. In fact, they are governed.
User A sends one bitcoin (BTC) using the peg-in transaction. The Liquid Network then pegged an equivalent of Liquid to Bitcoin (L-BTC) to users on the network as a representation of the real BTC. These L-BTCs are then used within the Liquid Network to perform infinite transactions until the participants finalize the transactions. Once it is done, users can peg out by exchanging L-BTC one-for-one for BTC.
Just like Bitcoin has Lightning Network, the Plasma Chain is Ethereum’s off-chain protocol. It operates independently of the main Ethereum chain, but is considered a “child” chain, anchored to the primary blockchain. It allows users to complete token transfers, swaps and other basic transactions off the Ethereum network at a lower cost and faster transaction speed. Plasma chains use fraud proofs and independent block validation mechanisms for security.
The term custody solutions refers to an independent service that stores and secures tokens, typically for institutional investors transacting large cryptocurrency volumes. Online wallets and private keys are also used to store tokens, but these aren’t foolproof. Each user’s keys include complex alphanumeric codes that can be difficult to remember and use, and these codes can be vulnerable to hackers. Online wallets are equally vulnerable to hackers. Custody solutions are an innovation signaling the developing interest of institutional investors in the ecosystem of cryptocurrency.
Are Off-Chain Transactions Better Than On-Chain Transactions?
Both off-chain and on-chain transactions offer specific benefits and drawbacks for cryptocurrency users. Blockchain technology has a scalability issue, which can be managed through off-chain solutions. Whereas on-chain transaction confirmation time can vary widely depending on network congestion, off-chain transactions execute immediately. The cost is also lower for off-chain transactions, which may have no fee at all until the transaction is added to the blockchain. Off-chain transactions can also offer more privacy, with the details of the transactions kept off the main blockchain and not broadcast publicly.
But there are trade-offs to off-chain transactions. For example, Liquid Network sacrifices Bitcoin’s decentralization for peg-in transactions, and Lightning Network requires BTC to be locked up and there’s a limited capacity of each payment channel. Essentially, there’s no permanent solution to on-chain transactions just yet. There are only trade-offs that fulfill the demands based on one’s need. As blockchain and crypto are evolving, there are chances for off-chain to be a permanent solution, but only time will tell.
The Bottom Line
Many factors can go into deciding whether to complete your transactions on or off the blockchain. Off-chain transactions tend to be best for those looking for fast, inexpensive and private transactions. On-chain transactions can be better for those seeking security, validation and immutability. Understanding the benefits and drawbacks of both on- and off-chain transactions — as well as what you want and need from your payment experience — can help you make the best decision for your needs.