On-Chain vs. Off-Chain Bitcoin Transactions
Table of Contents
- Bitcoin’s blockchain is the most secure, reliable payment system in the world.
- This security comes with trade-offs. Bitcoin transactions can take 10 minutes and transaction fees can be expensive.
- Off-chain solutions such as the Lightning Network, the Liquid Network, and others offer faster, cheaper transactions.
- Off-chain solutions come with trade-offs, such as capital requirements and trust.
Bitcoin On-Chain Transactions
Bitcoin uses a blockchain as a ledger to record all transactions. All bitcoin in existence can be found somewhere on the blockchain. All Bitcoin transactions recorded on the blockchain are considered on-chain transactions.
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Making an On-Chain Bitcoin Transaction
In order to execute an on-chain transaction, you must own bitcoin on the blockchain. This bitcoin will be locked in an address, and, using the private key corresponding to that address, you can sign a transaction sending this bitcoin to a new address. All on-chain transactions must pay a transaction fee in order to be included in a block. The higher the fee, the faster the transaction will be confirmed.
The Benefits of On-Chain Transactions
Bitcoin’s blockchain is the most secure database ever to exist. In 12 years of existence, it has never been hacked, nor has bitcoin ever been counterfeited or double spent on the blockchain.
Additionally, the Bitcoin network is extremely reliable. Bitcoin has an impressive uptime of 99.986% since its creation, and 100% uptime since 2013, meaning the Bitcoin network has never been down or unavailable since 2013. These levels are unmatched, not even by the largest tech companies in the world.
When you transact on-chain, you take advantage of this extreme security and reliability. Once your transaction is recorded on the blockchain, you can have ultimate confidence that it cannot be altered or reverted by anyone. Such guarantees are impossible to find with any other monetary system.
The Drawbacks of On-Chain Transactions
The cost of transaction fees is expected to rise as demand to transact on the Bitcoin blockchain rises. Indeed, in recent months, Bitcoin transaction fees have been increasing. For many users, especially those transacting in small amounts, transaction fees can be a significant cost.
Additionally, new Bitcoin transactions are confirmed on average every ten minutes. Therefore, getting your transaction confirmed can take anywhere from 10 minutes to multiple hours. While this is still an enormous improvement over the legacy banking system, it may be an inconvenience for some users.
To mitigate the downsides of on-chain transactions, several protocols and services exist to enable off-chain transactions, which typically offer lower fees and quicker settlement times.
Bitcoin Off-Chain Transactions
While there is only one Bitcoin blockchain, there are a many off-chain protocols that offer different benefits over on-chain transactions. Most off-chain protocols enable cheaper and faster transactions, but they also have drawbacks.
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The Lightning Network (LN) is a decentralized, peer-to-peer network which allows users to transfer bitcoin off-chain instantaneously, with practically no transaction fees. The Lightning Network is built on top of the Bitcoin network, and is thus called a layer two solution.
The Lightning Network enables two parties to lock up bitcoin in a multisig address, using an on-chain transaction called a funding transaction. The parties can repeatedly adjust the balances within that address using an arbitrary number of off-chain transactions. These transactions are instant and free. When the two parties are finished transacting, they can settle their balances using another on-chain transaction.
The Lightning Network allows a potentially infinite number of transactions to be compressed into two on-chain transactions, drastically reducing the transaction fees and wait times.
The Liquid Network is a sidechain protocol also built on top of the Bitcoin blockchain. The Liquid Network was created by the Blockstream corporation and operates on a separate blockchain. Liquid offers faster settlement than Bitcoin’s blockchain, as block reorganizations greater than 2 blocks are disallowed, and new blocks are produced every minute. Liquid also enables confidential transactions, which do not reveal the amount being sent, a feature currently unavailable on Bitcoin’s blockchain.
Liquid works by allowing users to send bitcoin (BTC) to a multisignature address on the Bitcoin blockchain. This transaction is called a peg-in transaction. After pegging in bitcoin, the Liquid Network will issue an equivalent amount of Liquid bitcoin (L-BTC) to the user on the Liquid blockchain.
L-BTC is an entirely separate token, and represents a claim to real bitcoin, much as paper currency used to represent a claim to gold. Once a user has L-BTC, they can transact rapidly and cheaply using the Liquid blockchain. When they are finished transacting, they can redeem their L-BTC for real bitcoin using a peg-out transaction.
Unlike Bitcoin’s blockchain, Liquid is not trustless and decentralized; It is governed by a federation of parties. The large number of parties should make the Liquid Network resistant to corruption, but the trust model is less secure than Bitcoin’s.
Fedimint is an open-source protocol that runs alongside a bitcoin node and provides operators and users a Chaumian eCash mint with Lightning connectivity. In this protocol, users’ funds are custodied by multiple guardians—federated in the sense that no single custodian controls all funds.
Users would be able to deposit funds into a federation using on-chain or Lightning, and could then transact privately using eCash notes. Since the protocol is directly compatible with Lightning, users could even pay Lightning invoices with eCash, for nearly perfect privacy.
Fedimints are based on second-party custody models; essentially, this means that users place their trust in their families, friends, and community. The transaction signing scheme is similar to multisig in that multiple guardians would need to be compromised in order for a loss of funds to occur. This model allows users to achieve better privacy and security with the ability to socially sanction community members in the event of a trust violation.
Most brokerages and exchanges, such as River, also function as off-chain Bitcoin platforms. After an initial on-chain transaction, you can trade your bitcoin any number of times. Instead of using the Bitcoin blockchain, your brokerage or exchange will simply record these transactions in their own private ledger. At the end of your trading, you can withdraw your bitcoin balance using another on-chain transaction.
The use of opening and closing on-chain transactions is similar to Lightning’s funding and closing transactions and Liquid’s peg-in and peg-out transactions. However, in the interim, while your bitcoin are held by the exchange, you do not have custody, nor do you control the private keys. In contrast to Lightning and Liquid, custodial platforms are fully trusted.
Trade-Offs Between On-Chain and Off-Chain Transactions
In the eyes of Bitcoin critics, one of Bitcoin’s weaknesses is a lack of scalability. Because each Bitcoin block can only hold a certain number of transactions, the blockchain will never satisfy users’ demand to transact in bitcoin.
Each off-chain platform offers benefits to users, but comes with its own drawbacks. The benefits of off-chain platforms are fairly consistent across different solutions: cheaper fees and faster transactions.
The drawbacks vary between off-chain platforms. For example, the Lightning Network requires capital to be locked up and Lightning payments are constrained by the capacity of each payment channel. The Liquid Network sacrifices some of Bitcoin’s trustlessness and requires 100 confirmations for peg-in transactions. Custodial solutions completely sacrifice trustlessness, transparency, and decentralization.
Each user should weigh these trade-offs when choosing how to use their bitcoin. Some use cases, such as long term holding, are best suited for the Bitcoin blockchain, while small frequent payments are likely best executed on an off-chain platform.
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