HomeCryptocurrencyBitcoinWhat is Bitcoin’s Liquid sidechain and why does it matter?

What is Bitcoin’s Liquid sidechain and why does it matter?

On October 10th, the Blockstream social media channels announced the successful launch of the Liquid Network. In a nutshell, the project is a Bitcoin sidechain whose birth is due to a collaboration between Blockstream and 23 of the biggest institutional players from the industry. At a quick glance, one can spot on the list of participating entities names like Bitfinex, BitMEX, Coinone, OKCoin, and Xapo.

All of these parters have been picked carefully in order to create a geographically-diverse network which ensures a maximization of decentralization. Sure, the Liquid Network isn’t and will never be as decentralized and open as the Bitcoin protocol — but that’s not the point.

Why does Bitcoin need a sidechain? It’s all about scaling the king of cryptos to make it handle transactions in a more efficient way. The unexpectedly high demand during the fall of 2017 showed the protocol’s technical limitations, and the efforts to help the system scale have been prioritized to a great extent.

From SegWit to the Lightning Network, we’ve seen it all happen quite fast as opposed to the slow conservatism Bitcoin used to be known for. But this time we’re witnessing a project whose scope and practices differ very much from the previously-mentioned publicly-accessible solutions: Now it’s about the needs of Bitcoin exchanges.

Why does Bitcoin need Liquid?

If SegWit brought the block malleability fix which allows the blocks to increase in size in times of higher demand, and Lightning allows network participants to open payment channels for the purpose of settling transactions without bloating the blockchain, then Liquid is very different. First and foremost, it’s what Blockstream calls “a federated sidechain” — the governance is concentrated in the hands of a few institutional elites which engage in trade.

The idea is simple: Why validate each individual transaction on the main chain and take the risk of dealing with network congestion when you can take your operations on a sidechain and request for validations only when it’s necessary to do so? It’s a second layer for settlements which promises to deliver confirmed transactions within two minutes, provide greater efficiency thanks to a common ledger which exchanges share between themselves, and even enable private transactions where only the sender and the receiver are able to see the ongoing amounts.

Bitcoin exchanges often trade large amounts of BTC among themselves, and the operations can be unpredictable in terms of settlement time and fees. That’s why Blockstream brought this solution to these institutional actors: To create convenience and predictability while freeing up some space in the Bitcoin blocks. Ultimately, the adoption of Liquid is beneficial for both casual users who make transactions on the main chain and exchanges which choose the federated sidechain, as the reduced number of operations which miners process generates quicker validation times and lower fees.

Differences between Liquid and Lightning

Both Liquid and Lightning were created to help Bitcoin scale, but serve different purposes. Liquid caters to the needs of Bitcoin exchanges which seek to cut costs and increase efficiency, while Lightning is more universal and allows parties to trade by opening transaction channels. At the core, they both exist to help Bitcoin scale in an uncompromising way, which doesn’t take away its inclusiveness as a protocol or its qualities of trustless and censorship-resistant sound money. Nevertheless, they accomplish this task in different ways and with different types of users in mind.

One major difference between the two sidechains is that Liquid is much more centralized. While Lightning allows anyone to run a node in order to participate in the system, the federated nature framework of Liquid only enables an institution to be a part of the governance. Given its scope and purpose, it makes sense for Blockstream’s solution to feature a greater concentration of power: Bitcoin exchanges transact very large amounts of coins and require predictability and reliability. Such actors aren’t necessarily interested in the micro-transactions which Lightning enables, and would rather have a closed protocol that’s tailored for their needs and interests.

The governance and selling point of Liquid

As previously established, Blockstream’s Liquid is much more centralized than both the Bitcoin protocol and the Lightning Network and currently involves 23 of the biggest names from the institutional side of the industry. These stakeholders have been selected on the basis of geographic criteria in order to enable diversity and avoid situations where power gets concentrated in the hands of a greedy faction, or the governments of a certain region manage to take over the network. That’s why the list includes exchanges and financial institutions from all across the world.

In the true spirit of Bitcoin, there isn’t one party which can impose a certain version of the protocol. The system functions on the basis of consensus, each individual institution can own only one server, and the participants must vote whether or not an update is made. In the beginning, Blockstream will provide a neutral and commonly-agreed version of the Liquid Network — but as time goes by and unpredicted situations arise, certain improvements might get proposed. If one party isn’t happy about the changes, then it can choose not to run the update and therefore push all the participants to find consensus for the sake of keeping the system functional.

An important feature of Liquid is given by the confidential transactions, and this might just be the selling point of the protocol. And yes, institutional actors which opt to use the protocol will pay a monthly subscription fee which might prove to be more convenient than paying higher fees for main chain transactions and having all the operations visible to anyone else.

Last but not least, it should be mentioned that the Liquid Network is capable of functioning with other cryptocurrencies. At this point, since every other coin is a lot cheaper and faster to transact than Bitcoin, it doesn’t make much sense for exchanges to opt for this scalability solution. But the situation can definitely change during the next bull run, especially in the case of Proof of Work projects. And then again, there’s always the convenience of confidential transactions which institutional actors definitely appreciate.

When asked to comment on the impact of the Liquid Network has on both Bitcoin exchanges and average users, Blockstream CSO Samson Mow said the following:

The Liquid Network is designed for inter-exchange settlement – that means moving funds quickly between exchanges, or between exchanges and OTC desks. For exchanges, it would mean more trading volume if coins are easier to move quickly; OTC desks would be able to source bitcoin from Liquid exchanges and take delivery in minutes. It really depends on what you define was a Bitcoin user, but traders would be able to move funds between exchanges within minutes to take advantage of arbitrage opportunities. Also, once Liquid wallets are released, traders could pull L-BTC off exchanges at the end of a trading day, knowing they can deposit back in minutes.

Featured image courtesy of Blockstream.

 

Written by

Vlad is a political science graduate who got a little tired and disillusioned with the old highly-hierarchical and centralized world and decided to give this anarchistic blockchain invention a little try. He found out about Bitcoin in 2014, had to do a presentation about it at Sciences Po Paris in 2015, but was too foolish to buy any. Now that he’ll never be a crypto millionaire and hasn’t acquired his golden ticket to lifelong financial independence, he’ll just write op-eds on various topics.

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