What Is An Off-Chain Transaction?

When people find the limits of an existing technology, they inevitably look for ways to improve it.

Satoshi Nakamoto’s public unveiling of Bitcoin in January 2009 permanently changed the intersection of money and the internet. With such a strong foundation of new financial technology laid in a completely open-source fashion, it wasn’t long before legions of new currencies were launched to different ends. As the first piece of blockchain technology out there, Bitcoin was the cryptocurrency that launched a thousand cryptocurrencies.

These emergent currencies had names like Litecoin, Ethereum, Namecoin, and Dogecoin. Each was slightly different in its own way, but each borrowed essential DNA from its Bitcoin progenitor: they depended upon a decentralized network to send and receive financial transactions, and nodes on these networks verified each transaction.

Whichever cryptocurrency (or cryptocurrencies) someone chose to dabble in, this category of technology made it possible to transmit value around the world without any geographical or political limitations.

But it wasn’t always fast or cheap to do so! Sending and receiving crypto within a blockchain’s native network, no extra add-ons involved, is called an on-chain transaction. Even though these transactions might happen exactly according to the design of the system, they could occasionally be slow and expensive to conduct.

So people started looking off the chain for improved second layer solutions.

“Second layer” refers to the projects, platforms, and protocols that work on top of a base blockchain to improve the underlying technology and user experience.

“Off-chain” refers to a transaction that happens outside of a main blockchain and isn’t published there.

The most intuitive form of a second layer (or off-chain) transaction is for two parties to agree to a debt between them. If we establish that I owe you one Bitcoin, our agreement is a “transaction” that stays valid by virtue of the fact that we trust each other.

If we keep a running total of the times I take you out to lunch and keep a running deduction of it from my debt, these can be said to represent further transactions as well.

None of this touches the blockchain, and the “transaction time” is virtually instant — we just need to do some math and agree on a remaining amount owed. At a certain point, we might settle the remaining amount owed with a single on-chain transaction representing all the activity that led to this single payment.

But second layer solutions (like this basic example) are about adding enhanced functionality to a blockchain beyond what the developers initially envisioned, or beyond what they designed that particular blockchain to do. When users of a major public blockchain perceive it to have certain shortcomings, they look to the second layer for answers.

Second layer transactions are faster and less expensive than their on-chain counterparts.

Yes, the Bitcoin blockchain unlocks a new paradigm for sending and receiving money, but those wanting to use it as an everyday mainstream payments solution only feel friction. Cash payments settle instantaneously, with the recipient only needing to count the money to confirm he or she has received the proper amount. Credit card payments are effectively just as fast — a cashier swipes your card at the register and has your payment confirmed (or denied) within a fraction of a second.

This is the kind of graceful experience that many people want with Bitcoin, but on-chain transactions just aren’t there yet.

Bitcoin for conventional payments are like asking a cashier to wait ten whole minutes to confirm your credit card payment. Cryptocurrency technology depends on a decentralized network scattered around the world in order to verify transactions. It takes essential time to get all those network nodes on the same page.

There are thankfully some compelling off-chain solutions to remedy this problem.

Bitcoin’s Lightning network is probably the most notable example of a second layer solution.

Let’s draw an analogy to the internet to illustrate how the Lightning network operates. On-chain transactions nowadays are like the 1970s internet. If you wanted devices to “talk” to each other, they needed a hardwired connection. This is no big deal if you’re networking two or three devices total, but the internet is a global network. The number of networked devices only grows, so gets quickly unsustainable to have cables running from everywhere to everywhere, which is how we arrived at internet routing — the connection between two computers doesn’t need to be direct.

Data can instead go through intermediary devices before reaching its destination, like a delivery company passing letters between two people who aren’t driving and delivering letters themselves.

Bitcoin’s Lightning network is to blockchain technology what the routing is to internet technology. It makes it a much simpler task to get a large number of crypto wallets talking to each other without any “wires” involved — it sees everyone connect to the network at once. People can open a Lightning channel to more quickly transact BTC with each other.

Because on-chain transactions require time and money to execute, participants in a Lightning channel each allocate a designated amount of crypto (let’s say it’s one BTC), and the channel keeps track of how the balances change over time.

If I want to send someone 0.1 BTC, Lightning will update our channel balances to be 1.1 BTC and 0.9 BTC. If they want to send me 0.5 BTC back, the balances are updated to be 0.6 BTC and 1.4 BTC. In figurative terms, Lightning keeps track of everything on a piece of paper, scratching out old balances and writing down the new balances every time we transact. And it’s fast!

Second layer transactions are only going to become more popular.

As a second layer solution to Bitcoin’s perceived on-chain shortcomings, Lightning doesn’t depend on confirmations coming from a decentralized blockchain. This makes it much faster and cheaper to transact with.

It reeks of appeal for those wanting to transact in crypto as though it were cash — it’s not a replacement for on-chain transactions, but a distinct enhancement to them.

The original scope of blockchain technology (as described by Satoshi Nakamoto) was nothing less than the underpinning of a new, radically inclusive economy. Second layer transactions only add new capabilities to this technology, making it more user-friendly and easing certain pain points associated with different conversions and cross-chain interactions. Even though they’re a kind of “after-market” solution, they make Nakamoto’s invention more versatile and robust.

For those already involved in crypto, the appeal of off-chain is clear. Faster payments attract more players to the space — going to the second layer will help make this niche technology more mainstream.