Since 2009, Bitcoin has taken the world by storm. Bitcoin’s enormous popularity is due to several factors, including its simplicity and convenience as a reliable payment system. Bitcoin allows you to make fast, easy and secure peer-to-peer payments and is decentralized. The decentralized nature of the network ensures greater transparency and increases trust.
Bitcoin uses the blockchain as a ledger to record all online transactions in the chain. It uses multiple nodes instead of a centralized server, and every transaction is verified, logged, and shared between multiple nodes. Because there’s no need for regulators or heavy paperwork, overheads and the risk of errors are reduced.
However, the picture is not entirely rosy. Security comes with tradeoffs, especially transaction costs, which can add up during peak network times. Processing speed can also become excruciatingly slow during peak hours. Removing certain transactions from the blockchain can potentially simplify, speed up and reduce the cost of your Bitcoin transaction.
This begs the question: Are off-chain transactions the ultimate solution? And what are some of the disadvantages? Before we begin, let’s understand how a distributed ledger works.
Blockchain distributed ledger explained
Blockchain is a type of distributed ledger that stores, shares, and synchronizes transactions in a shared electronic database. Blockchain technology was first described in 1991 and is designed to record events without the ability to tamper with the timestamp. When Bitcoin was launched in 2009, it incorporated blockchain technology.
In a distributed ledger, independent computers called nodes store transactions and other information in their respective electronic ledgers, unlike a centralized data store such as a traditional bank ledger. Data is organized into blocks which are chained together to form a blockchain. In it, anyone can view the entire transaction history and prove that there is no double spending of the coin. The resulting ledger can then be distributed to the various nodes that make up the blockchain network.
Distributed ledgers offer several advantages over traditional databases. First, they eliminate the need for third-party oversight, which is what makes them so attractive to cryptocurrencies. For example, the proof-of-work blockchain provides an objective way for nodes to confirm the order of transactions. Users can significantly save time, effort and blockchain transaction costs by bypassing the middleman and storing their transactions directly on the blockchain.
The decentralized nature of distributed ledgers makes them inherently secure. It is difficult or even impossible for remote attackers to access them. The data they contain is highly transparent and distributed across all nodes, freely available and easy to view. This transparency and accessibility make them popular not only in cryptocurrencies like Bitcoin, but in other industries as well.
Finally, distributed ledgers are also immutable and immutable. A single user cannot change the information they contain, providing an extra layer of protection for all users.
What are intrachain transactions?
Miners validate Bitcoin on-chain transactions and record them on the blockchain. Once transactions are added to the ledger, the blockchain network is updated and shared.
A transaction has to go through several stages before entering the blockchain. To perform an on-chain transaction, you need to own Bitcoin on the blockchain and have it locked to an address. The private key is used to send Bitcoins to the recipient’s address. Each user performing an on-chain transaction must pay a transaction fee, which varies depending on the size of the transaction in bytes and the current amount of network traffic. Network congestion can slow down transaction processing, and a Bitcoin transaction with a higher fee is usually prioritized and confirmed faster.
The Bitcoin network is safe and reliable due to its transparency. Since the blockchain is open and the ledger is available to all network participants, counterfeiting or double spending is unlikely to occur. Security is guaranteed by the immutability of the blockchain. Nothing can be changed, including transaction data, timestamps, or other block data.
Disadvantages of Bitcoin On-Chain Transactions
On-chain transactions offer many advantages in terms of security, but blockchain’s scalability, speed, and cost come with limitations.
Scalability has been an issue that has plagued Bitcoin almost since its inception. The Bitcoin system can be cumbersome and expensive because it can only handle about seven transactions per second. For this reason, many users tend to keep lower value transactions off-chain to reduce network congestion.
Network congestion can cause delays. Confirmation of on-chain transactions can be slow, and accepting an unconfirmed transaction carries risks. For example, Bitcoin transactions are confirmed in an average of ten minutes, although it can take up to an hour depending on the state of the network. An off-chain transaction can be recorded immediately, which eliminates the risk of cancellation.
Finally, payments are a necessary part of doing business both on and off the blockchain. Miners charge fees for verifying transactions. Unfortunately, these fees can skyrocket as network congestion increases, leading to higher transaction costs.
Understanding state channels
State channels allow users to perform Bitcoin transactions directly from the blockchain and minimize the use of on-chain operations. This option uses smart contracts that define the rules by which an off-chain transaction can occur. Each off-chain transaction creates new states and must be signed by the parties involved. The new status cancels all previous statuses.
To use the state channel, each party must open a channel transaction and deposit an appropriate amount of currency. Parties can then start making off-chain transactions using the channel, and the smart contract ensures that no double spending occurs. The combined transactions correspond to the total amount of deposited currency. When the channel is closed, the final result is added to the blockchain.
How do off-chain transactions work?
Off-chain transactions are any transactions that are processed outside of the blockchain. These second-layer protocols seek to circumvent the chain’s shortcomings by enabling a cheaper and faster transaction.
Users can open a channel and exchange private keys to that wallet, allowing funds to be transferred off-chain. As long as the channel is active, they can continue to exchange currency as much as they want until they are ready to settle, at which point they can close the channel and save the final result to the chain.
Unlike on-chain networks, there are plenty of off-chain protocols. These include Lightning Network, Liquid Network and more. Let’s dive into it.
The Lightning Network is a Layer 2 protocol built on top of the Bitcoin blockchain that allows users to participate in unlimited transactions instantly and at low cost. The Lightning Network also enables inter-chain atomic exchanges, providing even greater convenience and versatility without the need for third-party custodians.
It is a decentralized peer-to-peer network, which means participants can trade by locking their Bitcoin addresses into a multi-signature address using a financial transaction. Participants can perform an infinite number of transactions repeatedly with an off-chain transaction address until balances are finalized on the blockchain.
Liquid Network is a sidechain protocol, which means it relies on the Bitcoin blockchain for data, but operations are performed separately. Like the Lightning Network, it is built on top of the Bitcoin blockchain and allows users to transact off-chain while enjoying security and privacy. Liquid Network is faster than the main blockchain and cheaper, and it is confidential, meaning it does not reveal the amount of currency associated with a given transaction. The only downside is that Liquid is not decentralized. In fact, they are managed.
User A sends one bitcoin (BTC) using a join transaction. Liquid Network then attached a Liquid to Bitcoin (L-BTC) counterpart to network users to represent real BTC. These L-BTCs are then used on the Liquid Network to perform infinite transactions until participants complete the transactions. Once that is done, users can merge L-BTC one-by-one with BTC.
Just like Bitcoin has Lightning Network, 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 perform token transfers, exchanges and other basic transactions outside of the Ethereum network