What Is A Bitcoin Off-Chain Transaction?

Btc offchain transaction explained

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Bitcoin uses a blockchain as a method of recording all transactions; this distributed ledger is held in consensus by thousands of nodes run by individuals and institutions across the globe. All bitcoin can be viewed on the blockchain, along with the public addresses that hold them and transaction history. All Bitcoin transactions recorded on the blockchain are considered on-chain transactions. To allow bitcoin to remain decentralised, these nodes need to remain in sync, and with that comes a limitation on the number of transactions that can be processed every 10 minutes once a block is secured.

A method of getting around the limitations of the blockchain is to move your transactions off-chain.

Off-chain transactions are balances that exchange funds with two peers without the need to confirm it on the base chain, and these balances can later be updated on the primary blockchain. These transactions can be confirmed instantly and are much cheaper than on-chain ones, as they don’t have to compete in the mempool fee market for miners’ attention. 

While there is only one bitcoin blockchain, there are many off-chain options that offer different benefits over on-chain transactions. While off-chain protocols enable cheaper and faster transactions, but they also have drawbacks.

Exchange transfer

The first method of transferring bitcoin off-chain is to use a custodian. There are many centralised exchanges and CeFi platforms that allow users to open an account with them and transfer funds between other users with accounts. This is similar to how you would transfer funds between users of the same bank or users of the same Fintech app like Paypal.

For example, a user can send bitcoin from their exchange wallet to their wallet on the same exchange using the email or cell number attached to that exchange account. This transaction will take place off-chain, and balances will be updated accordingly.

In this example, you are not moving real bitcoin, but bitcoin IOUs that you hope are backed 1-to-1 with bitcoin in the exchanges treasury. You are placing trust in the exchange to honour these balances that you hope to redeem to the bitcoin blockchain when you are ready to go on-chain. This option is great for small amounts of bitcoin that might not be worth paying mining fees as many exchanges offer free transfers between accounts.

Apart from the trust, you place in the custodian using this method; you are also faced with the limitation that you can only transfer funds between uses of the particular exchange or app.

Liquid Network

The Liquid Network is a sidechain protocol and fork of the bitcoin blockchain. The Liquid Network was created by the Blockstream corporation and operates on a separate blockchain without a native token or proof of work. Liquid offers faster settlement than Bitcoin’s blockchain, though confirmations are handled by a federation of different members.

Liquid allows users to send bitcoin (BTC) to a multi-signature address on the bitcoin blockchain, which is known as a peg-in. After pegging in bitcoin, the Liquid Network will issue an equivalent amount of Liquid bitcoin (L-BTC), which you can use on the Liquid chain to perform transactions far faster and cheaper.

The liquid network is not trustless and is distributed rather than decentralised; It is governed by a federation of parties. The wide variety of federation members adds resistance to corruption, but the trust model is less secure than bitcoin’s time chain.

Lightning Network

The Lightning Network (LN) is a decentralised, peer-to-peer network which allows users to transfer bitcoin off-chain instantaneously, with extremely low transaction fees. The Lightning Network is built on top of the bitcoin network and enables peer-to-peer payments through payment channels.

The Lightning Network enables two parties to lock up bitcoin in a multi-sig address using an on-chain transaction called a funding transaction or channel open, so you’ll need to do one on-chain transaction first. Still, once that’s done, you can keep making transactions inside the channel. Lightning peers can repeatedly adjust the balances within that address using an arbitrary number of off-chain transactions.

Paper bitcoin

It is possible to create an offline bitcoin wallet, known as a paper wallet containing a public and private key pair for making bitcoin transactions. It is generally created with a key generator program and printed on paper as two strings of characters and two Quick Response (QR) codes.

A paper wallet is a non-custodial cold storage wallet — meaning you control the keys yourself, and the wallet is not connected to the internet. Yet, it can be vulnerable to exploits depending on the application you’re using to create the paper wallet and the printer and internet connection you’re using.

Once you’ve created and funded a paper wallet, that private key will hold a set of bitcoin. You can then hand that piece of paper over to someone to make a physical transaction the same way you would with cash.

The recipient would then need to check the public key to ensure the bitcoin is still in the wallet and would need to restore the private key to a wallet to claim the funds. The paper wallet holder would also need to move those funds to another wallet since they cannot be sure if the paper wallet they received is the only copy.

Creating a seed phrase

Another option similar to creating a paper wallet is to create a standard bitcoin wallet with 12 or 24 words; once you’ve created the wallet, you can then fund it with bitcoin and delete the software wallet that you used to create the seed phrase.

You can then hand over that seed phrase funded with bitcoin to someone you wish to pay; since you’re only handing over ownership of the seed phrase, the bitcoin is not moving rather, the access to that bitcoin is moving.

In the case of handing over the seed phrase, there is trust involved since you need to hope that the person handing over the seed phrase won’t sweep the wallet before you can access the funds or that they’ve handed you an empty wallet.

OpenDime

An Opendime is a small USB stick and temporary bitcoin hardware wallet that allows you to transfer bitcoin physically but tries to remove the trust assumptions you make by passing over a paper wallet or a seed phrase. Users who receive the OpenDime can connect it to any USB to check their balance, and you have to physically unseal the wallet to spend the funds.

Use resources wisely

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.

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.

There is no second best when it comes to on-chain

As bitcoin scales and reaches more people, it must facilitate more off-chain transactions to ensure that block space isn’t bid up to unusable levels and that transactions can clear in reasonable time frames. While off-chain will be part of the bitcoin ecosystem as current second layers expand and new third layers come into play, there is no substitute for final settlement.

As a bitcoiner, it’s up to you to decide how you exchange value with others and learn to use the available options and the trade-offs involved. Options like Liquid and Lightning are great for those wanting to trade, for commerce and interact with financial applications, while on-chain is always an option should you feel the need for final settlement.

If you want to store bitcoin long-term, you want to remove trust from the equation, and only an on-chain transaction can offer you that.

Disclaimer: This article should not be taken as, and is not intended to provide any investment advice. It is for educational and entertainment purposes only. As of the time posting, the writers may or may not have holdings in some of the coins or tokens they cover. Please conduct your own thorough research before investing in any cryptocurrency, as all investments contain risk. All opinions expressed in these articles are my own and are in no way a reflection of the opinions of The Bitcoin Manual

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