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Off-Chain Transactions Explained

Off-chain transactions occur outside of a blockchain network and as a result, are generally cheaper and faster than on-chain transactions but do not fully benefit from the inbuilt security offered by a crypto blockchain.

The crypto space is getting busier and ever-popular by the day, transaction volumes are growing at a rapid pace and this inevitably means traffic. 

Not the kind of traffic people want like increased visits to their website, but rather being horribly stuck in slow-moving traffic on a highway. 

The highway in crypto terms of course being a blockchain network like Bitcoin or Ethereum for example.

Continuing with the highway analogy, a blockchain such as Bitcoin has its limitations, just as a highway has a fixed amount of lanes. 

As the number of cars (transaction blocks) using the highway increases this results in a slowdown and this increased demand can lead to a rise in toll fees, or transaction fees in crypto.

In order to try and reduce or even eliminate fees, speed up transaction times and perhaps even maintain greater anonymity some people go off-chain for their transactions. 


The benefits of on-chain or simply regular transactions

Before we can look at what off-chain transactions are we should first acquaint ourselves with on-chain or simply regular transactions taking place on the blockchain. 

A blockchain is literally a chain made up of blocks of data. 

These blocks are validated by independent nodes on what is known as a decentralised peer-to-peer network, as opposed to a centralised network. 

This peer-to-peer setup with no central organisation and an extremely robust system of validation makes a cryptocurrency like Bitcoin rock solid. 

In fact, in Bitcoin’s entire existence, it has never been hacked nor has Bitcoin ever been counterfeited or double spent on the blockchain. 

Furthermore, the Bitcoin network is highly resilient with a highly impressive uptime of 99.986% since its inception and 100% uptime since 2013. 

This level of uptime and resilience is hard to match even by the largest tech companies in the world. 

Being so rock solid and secure makes a blockchain and by extension a cryptocurrency like Bitcoin so attractive as a means of holding and transferring value between total strangers. 

Despite these advantages, there are limitations and this has led to the use of off-chain transactions.


On-chain transactions also have their downsides

Naturally, on-chain or regular blockchain transactions offer a huge amount of benefits but there are downsides too which have resulted in the growth in demand for off-chain transactions. 

Bitcoin transaction fees are expected to rise as demand for Bitcoin and other cryptos rises. 

For many users, especially those making small transactions the fees can represent a significant or unfeasible cost. 

In addition, getting transactions confirmed on the Bitcoin network could take anything from 10 minutes to several hours. 

Compared to legacy banking this is already a big improvement but for many, it’s simply not fast enough!


What are off-chain transactions?

To combat the downsides of on-chain transactions several protocols and services exist enabling off-chain transactions with lower fees and quicker settlements. 

Off-chain transactions deal with values externally from the blockchain and usually come about via several methods. 

These can include two parties having a private transfer agreement, maybe something like the private sale of a vehicle between two parties or a third party may exist that validates and guarantees a transaction.

Think of a 3rd party like Amazon sitting in the middle to ensure that the correct product ordered from party A in the marketplace makes it to party B as promised and on time and the seller gets the appropriate payment minus fees of course. 

Without the Amazon marketplace or a similar 3rd party, the user would be sending money to the seller in the hope that everything will go well. 

A huge company like Amazon with its market strength and dominance provides the required level of confidence just as a blockchain does. 

Amazon however doesn’t do this for free, there are costs involved just as there are transaction fees involved with blockchain transactions.


Another off-chain method uses a code-based payment mechanism. 

In this case, one party purchases a redeemable code to exchange against a crypto asset. 

They give this code to a third party who then redeems the code either in the same crypto asset or a different one depending on the service provider.

All of these individual transactions are happening externally and are therefore not restricted by the speed limitations or transaction fee requirements of the blockchain but also do not benefit from the full amount of security benefits afforded by the blockchain. 

There is naturally a trade-off, speed and lower fees in exchange for perhaps a small loss in security.


A couple of off-chain transaction providers includes Lightning Network and Liquid Network

One example of an off-chain network is the Lightning Network, a decentralised peer-to-peer network that allows users to transfer Bitcoin off-chain instantly and less transaction fees, so, faster and cheaper than on-chain. 

The Lightning Network is built on top of the Bitcoin network and is known as a layer-2 solution.

Another example is the Liquid Network which also offers speed and cost advantages but uses what is known as a sidechain protocol. 

The primary difference between layer-2 and sidechain solutions is the difference in their security mechanisms. 

Layer-2 relies on the security of the main chain, e.g. the Bitcoin blockchain whereas sidechains have their own security mechanisms. 

However, both have pretty much the same goal, to reduce transaction times and fees.



As crypto has exploded in popularity it has inevitably meant an increase in cost and a slowdown in transaction times. 

As a crypto blockchain like Bitcoin is pretty hard-wired, alternative ways to scale are continually being explored. 

Off-chain transactions are one way to reduce the transaction load and offer users a cheaper and faster alternative even if there are a few tradeoffs involved.

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Crypto layer-2

Layer-2 is a scaling solution to enable faster and lower-cost transactions on a blockchain network like Bitcoin or Ethereum.

As crypto has exploded in popularity it has inevitably stretched the capabilities and limitations of the major blockchain crypto networks like Bitcoin and Ethereum.

You could imagine the early days of crypto like a shiny new three-lane highway, freshly tarmacked for a smooth ride and almost no traffic due to the relatively small number of cars. 

Fast forward to today and that same highway is bursting at the seams just as our real highways are. 

It’s not easy or sometimes even possible to add a new lane to ease the traffic. Crypto networks like Bitcoin and Ethereum face a similar dilemma.

The limitations of layer-1 when it comes to transaction speed

The core blockchain network is what is known as Layer-1. 

In the case of crypto, one major problem with layer-1 is the relatively slow speed at which transactions can be confirmed. 

Take the case of the credit card company Visa, it is capable of processing up to 20,000 transactions per second (TPS).

Bitcoin on the other hand is capable of 3 to 7 transactions per second on the main blockchain. 

This is a gigantic difference and poses serious scalability issues. 

The reasons why are too complex to get into here but in essence, Visa uses a centralised system whereas Bitcoin uses a completely decentralised system where every single transaction needs to be verified by every node on the blockchain. 

This produces a highly secure, cost-effective and super-resilient network but this security and robustness comes at the cost of lower transaction speeds. 

Layer-2 is one solution to the problem of scaling

As a result technologists in the crypto world have been exploring ways to ease this congestion and layer 2 is one such solution.

To illustrate what layer-2 is we can use a different analogy this time. That of banking. 

Imagine a major bank like HSBC or Barclays. It has a centralised technology or systems that store all the balances and transactions for thousands or maybe even millions of customers. 

Every time money is deposited, withdrawn or transferred by an account holder the information is updated on the central network and most often in real-time. So far so good. 

Now imagine we didn’t have online banking or ATMs and like the old days of banking, every single customer would have to physically visit a branch office and conduct the desired transaction no matter how small. Imagine the queues! 

Well, this is what layer-1 kind of looks like. 

As you can imagine, even with lots of branches it would take a lot of time to get things done. 

Banking solved much of this problem by going online and by offering ATMs. 

This has resulted in a huge amount of daily transactions being removed from the workload of branch offices. We could think of ATMs and online banking as layer-2 in crypto.

Now that we have an idea of what layer-1 and layer-2 are we can go a little deeper into what they are in crypto terms

Blockchain networks like Bitcoin and currently Ethereum, (although this will change), use what is known as a Proof of Work (PoW) consensus mechanism. 

In simple terms, every time a transaction or “block” is recorded on the blockchain a miner has to solve a highly complex computational puzzle first by beating other miners and winning the opportunity to record the new block and in return earn some coins and corresponding transaction fees. 

This transaction has to be verified by the entire blockchain network and then it is set in concrete so to speak. 

This process takes time and energy, literally. If this proof of work consensus mechanism didn’t exist, say in the case of Visa, a transaction could be recorded instantly and naturally 20,000 transactions per second are possible. 

In the case of Bitcoin, it is a physical limitation due to how the blockchain was originally conceived and developed. 

Layer-2 is designed to divert transactions from the layer-1 network onto a faster network

What layer-2 does in very simple terms is “divert” a transaction away from the main layer-1 network, process it on a faster separate layer, “layer 2” and then when the transaction has been completed punch it back into the main layer 1 and set it in concrete so to speak. 

This results in a reduction in small transactions occurring on the main layer 1 of the blockchain but still recording the final transaction with the same level of surety. 

In addition to reducing congestion layer-2 also helps by offering lower transaction fees which are essential for very small transactions or micro-transactions where high fees simply wouldn’t work.

We could go back to the highway analogy again to illustrate layer-2 as well. 

Imagine the main highway as layer-1, the primary blockchain of say Bitcoin or Ethereum. 

Layer-2 could be an exit onto a separate super wide and fast stretch of road that leaves the main highway and then rejoins again several junctions later. 

Now if we imagine a lot of these separate stretches of road in existence that are diverting traffic away we could expect a reduction in traffic on the main layer-1 highway. 

Of course, it’s not as simple as that but hopefully, the analogy makes it easier to understand the issue and how layer 2 can ease congestion.

The Lightning Network is an example of a layer 2 crypto scaling solution for Bitcoin

One example of a layer-2 scaling solution is the Lightning Network on the Bitcoin blockchain. 

The Lightning Network simultaneously takes transaction loads from the Bitcoin layer-1 and reports to it as well. 

This results in an increase in processing speed on the Bitcoin blockchain. In addition to this, the Lighting Network brings smart contract capabilities to the Layer-1 Bitcoin blockchain. 

This is pretty major as the layer-1 Bitcoin blockchain, unlike Ethereum, does not inherently support smart contracts. 

Smart contracts, in very simple terms, are automated contracts that allow for more complex possibilities on a blockchain beyond the storing and transferring of cryptocurrencies. 


As with almost all new technologies that experience mass adoption, like banking or cars, there is inevitably going to be a scaling problem. 

Crypto is experiencing this scaling problem right now. In order for crypto to truly go mainstream robust solutions will be needed. 

Layer-2 is one such solution trying to help ease congestion and keep traffic moving!

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