When talking about cryptocurrencies, off-chain refers to the processes that happen outside the blockchain. One of blockchain’s primary issues is scalability, as decentralized consensus algorithms are generally slower than centralized transaction processing. Off-chain solutions aim to improve the blockchain’s throughput by processing part of the data outside the main chain.
Off-Chain Transactions
Off-chain transactions are value transfers facilitated either using a third party as a form of guarantee or other methods, with only the final state of the balances being recorded on the blockchain itself. They offer benefits, such as lower fees and a faster transaction processing speed as the validation isn’t performed by nodes. That makes off-chain transactions perfect for small-scale payments like coffee purchases at a local shop.
Off-Chain and Layer 2 Solutions
Layer 2 solutions are protocols built on top of an existing blockchain aiming to improve its scalability. They are projects that enable off-chain value transfers using mechanisms such as state channels, sidechains, and rollups.
In the context of Bitcoin, a popular Layer 2 solution is the Lightning Network, which uses state channels for off-chain transactions. The channels are essentially 2-of-2 multisig wallets that can only be modified when counterparties agree on the change. Only the transactions that open and close the channels are recorded on the Bitcoin blockchain; everything else is processed off-chain. Off-chain transactions inside of a state channel don’t need to be validated by the entire network, enabling faster throughput and lower transaction fees.
On-Chain vs. Off-Chain
While off-chain transactions occur outside the chain, the term “on-chain” describes the processes that happen directly on the blockchain (the main chain). On-chain transactions need to be validated by the peers and are confirmed only once recorded on the chain. Let’s take a look at the key differences between off-chain and on-chain.
Speed and scalability
For an on-chain transaction to be confirmed, it needs to be validated and included in the blockchain. As the average block confirmation time for Bitcoin is 10 minutes, the Layer 1 chain isn’t suitable for smaller purchases like buying groceries at a supermarket. Unlike on-chain transactions, off-chain payments don’t need to wait for miners or validators to be confirmed. As such, off-chain solutions can substantially increase the processing speed and are particularly useful for micropayments.
Privacy and security
On-chain transactions implement standard blockchain security practices like hashing and cryptography. In contrast, projects offering off-chain payments need to come up with security frameworks to prevent the possibility of forging or modification of payments.
Costs and fees
On-chain transactions are verified by the nodes that put in the work to validate them, include them in a block, and add that block to the chain. The block rewards and transaction fees incentivize them to keep the network running. Off-chain transactions can be processed quickly without the need for immediate confirmation, thus minimizing the costs and fees.
