One of the biggest issues facing Bitcoin is scalability and speed. Bitcoin’s underlying technology isn’t particularly fast and cannot process many transactions simultaneously. That’s a problem for the world’s most popular cryptocurrency.
One solution is Layer-2 blockchain protocols, which effectively add another processing layer to the original blockchain to increase capacity. The Bitcoin Liquid sidechain is a Layer-2 protocol that aims to solve Bitcoin’s scalability and speed issues, but how does it work, and how can you use it?
What Is a Sidechain?
A sidechain is a type of Layer-2 blockchain linked to the main blockchain to help process some of the data in the main blockchain. It enables the mainnet to grow its ecosystem by processing some transactions securely and faster. In this case, the Bitcoin blockchain is Layer-1, and the Bitcoin Liquid sidechain is Layer-2. There are other differences between Layer-1 and Layer-2 blockchains, too.
It makes it safe to move digital assets like tokens between blockchains, and it improves the privacy and security of the main blockchain by reducing the trust needed to keep a network running.
Sidechains are more centralized than mainnets and are responsible for their security, a trade-off for the speeds they achieve. They also need their own validators or miners but can adopt any consensus mechanism, whether proof-of-work, proof-of-stake, or even proof-of-space-time. Sidechains don’t need to use the same consensus mechanism as the main blockchain, which can help speed up processing.
In order for sidechains to operate effectively, i.e., to transfer and receive digital assets from the mainnet without allowing any duplication, two things are required: a two-way peg and smart contracts.
Two-Way Peg
A two-way peg is a mechanism that enables the transfer of digital assets between two separate blockchains. It involves a two-way, counter-directional process: locking up mainnet assets to the sidechains and releasing sidechain assets to the mainnet. So how does the two-way peg work?
The Liquid Sidechain two-way peg allows you to lock an asset on the mainnet and then mint an equivalent amount of that asset in the sidechain. When the assets need to be transferred from the sidechain back to the mainchain, they’re destroyed, and the equivalent amount of assets is minted in the main chain.
This creates a direct bridge between the two, allowing for interoperability. Essentially, no “transfer” actually happens. This means the “validators” involved in the operation are assumed to be acting honestly.
Smart Contract
The whole idea behind blockchain technology is to make it trustless. The validators in a two-way peg transaction process can’t be humans, which is where smart contracts come in.
Smart contracts validate that the digital assets locked in and released on either blockchain correspond to each other in value. They do this by enforcing validators on the sidechain, and the mainnet acts honestly when verifying the cross-chain transactions.
Essentially, when a transaction occurs on the sidechain, a smart contract notifies the mainnet about the event. The transaction information is then sent to another smart contract on the sidechain to verify the transaction.
Upon verification, the representative digital assets in the sidechain are destroyed, and the equivalent digital assets in the main chain are released to you. This process can take place in both directions.
What Is the Bitcoin Liquid Sidechain?
Bitcoin Liquid, also known as the Liquid Network, is a sidechain designed to offer solutions to the privacy and scalability limitations of the Bitcoin blockchain.
Unlike in Bitcoin, where blocks are mined with the proof-of-work mechanism, Bitcoin Liquid assigns each block to specialized hardware units known as “functionary nodes,” which sign transactions, generate new blocks, and secure the bitcoins linked into the mainnet.
To achieve better privacy, the Liquid Network uses tokens with transaction amounts, and asset types obscured using cryptographic techniques. These assets allow the network to support Confidential Transactions, resulting in more privacy.
Meanwhile, the Liquid Network achieves scalability through its support for two-minute block times, significantly faster than Bitcoin’s ten-minute block time. This allows for faster trading and settlement of assets on the network.
Who Controls the Bitcoin Liquid Sidechain?
Bitcoin Liquid was created by Blockstream, a company founded in 2014 by Adam Black, to develop products and services for the storage of digital assets.
Currently, it is managed by a federation of 63 trusted entities known as “Liquid Functionaries,” which comprises financial institutions, cryptocurrency exchanges, and other bitcoin-based businesses. These functionaries provide the validation and management infrastructure for the network.
How Does the Bitcoin Liquid Sidechain Work?
Bitcoin Liquid works through a federated peg mechanism that allows bitcoins to be locked up in the mainnet and an equivalent value of the asset released in the side chain in a 1:1 ratio.
Here’s how the Liquid Network works:
- To initiate a “peg in,” you first send Bitcoin to a specific address on the main chain owned by the Liquid Federation.
- Once the Bitcoin is confirmed, an equal amount of Liquid Bitcoin (L-BTC) is sent to your Liquid Bitcoin address on the Liquid sidechain.
- You can use your L-BTC to make transactions on the Liquid sidechain, which is faster and more private than the main chain.
- To “peg out” your L-BTC back to the main chain, you send the L-BTC to a specific burn address on the Liquid sidechain, and the main chain will release the same amount of Bitcoin once the transaction reaches two confirmations.
This system allows you to make faster and more private Bitcoin transactions without compromising the security and reliability of the Bitcoin blockchain.
Benefits of Bitcoin Liquid Sidechain
There are several benefits that the Bitcoin Liquid sidechain offers to both the Bitcoin blockchain and its users. They include
- Faster transactions: Based on block times, the sidechain can process transactions at least five times faster than the mainnet, reducing transactions to two minutes instead of ten. This takes off some of the transaction load on the Bitcoin blockchain. In addition, it makes it an ideal choice for arbitrage trading and retail investing, which needs faster transaction processing.
- Cheaper transactions: Normally, fees on the Bitcoin blockchain skyrocket when it gets clogged with transactions, and miners have to charge higher for prioritization. On Bitcoin Liquid, since the transactions are processed faster, the fees are lower and ideal for heavy users and institutional investors.
- Greater privacy: The Liquid Network uses Confidential Transactions that allow users to keep their transaction amounts and other information from public view. Hence, if you need a way to move Bitcoin that’s more privatized, the sidechain is a good option.
- Increased functionality: Bitcoin’s blockchain is very limited because its programming language, Script, is not Turing-complete, which means the issuance of digital assets is limited. However, with Liquid Network, users can handle assets such as tokens, stablecoins, and NFTs.
Overall, Bitcoin Liquid functions well as a load-reliever for the Bitcoin blockchain. Nevertheless, despite its effectiveness, it also has a number of disadvantages.
Drawbacks of Bitcoin Liquid Sidechain
The structural design of the Bitcoin liquid sidechain presents several issues.
- Centralization: The Liquid sidechain is operated by a federation of 63 functionaries responsible for maintaining the ledger and adding new transactions. Of the 63-member group, only 15 functionaries are active at any one time. As such, a centralized system is subject to control by few parties and isn’t ideal for people who value decentralization.
- Risk of failure: Bitcoin liquid has only 15 nodes from the functionaries sustaining the network compared to the Bitcoin blockchain’s thousands of nodes. This means there’s a high risk of malicious attacks, which would result in failures.
Notably, the Liquid Network’s design creates the same challenges blockchain technology was designed to solve: centralization risks.
Sidechains and Layer-2 Networks Will Help Build Crypto
If we’re to have a Bitcoin ecosystem that billions of people can use, the idea of using sidechains to expand its scope, scale, and dynamic is great. It means more people can make transactions without having to suffer slow speeds.
However, the sidechains built to support the mainnet, whether they’ll have different consensus mechanisms and governance rules or the same, will need to have a common vision while remaining independent.
Sidechains have a big role to play in improving cryptocurrency usage and adoption.
