Off-chain transactions are transactions that occur outside of a given blockchain network in order to bypass the flaws of the said network.
The Long Explanation
A typical blockchain transaction is recorded, validated and completed by the network on which it originates. Once this happens, the blockchain is modified to reflect the transaction on the public ledger, making the transaction irreversible.
Otherwise known as ‘on-chain transactions’, the process described above is the path taken for most transactions on any blockchain. The networks consensus mechanism is triggered, and must be satisfied for the transaction to be valid.
Unfortunately, while legacy blockchains like Bitcoin and Ethereum are often very secure, they face limitations around their scalability, speed and cost. Ethereum can only process 30 transactions per second, while Bitcoin is stuck at 7 transactions per second.
For two of the most widely used blockchains, those are terrible speeds; leading to the rise of off-chain protocols. Off-chain protocols or layer-2 protocols are blockchains that enable cheaper and faster transactions than the capacity of the main chain.
Layer-2 protocols are built on top of a primary chain to improve the underlying technology by extending its functionality or efficiency. For layer-2 protocols to work, both parties must agree on how transactions are to be settled.
This agreement enables second-layer protocols to facilitate transactions using their own consensus mechanisms. A transaction is, thus, recorded, validated and completed outside of the primary chain, with some math function used to determine what’s owed to the primary chain.
The accumulation of debt is then settled at a later time, as a single on-chain transaction. This process allows off-chain transactions to be completed instantaneously with little or no transaction fee and at least as much security as on-chain transactions.
Examples
Lightning Network:
A layer-2 Bitcoin protocol, Lightning Network was designed to allow instant and limitless Bitcoin transactions at minimal cost. The Lightning Network also supports cross-chain atomic swaps, without any need for third-party custodians.
Liquid Network:
Liquid Network is a sidechain protocol which draws data from the Bitcoin blockchain, while settling transactions off-chain. The Liquid Network is faster, more affordable, and more confidential than the Bitcoin blockchain, while enjoying the same security of the main chain. Unfortunately, it isn’t decentralized.
