If you are interested in crypto, you will be familiar with blockchains. These ledgers form the backbone of the crypto industry and perform a variety of functions, including transaction processing.
But crypto transactions are not all one and the same, and can be either on-chain or off-chain. But what does this really mean? What is the difference between on-chain and off-chain in crypto?
What is a chain transaction?
As the name suggests, chain transactions take place on a blockchain. On-chain transactions are extremely common in crypto, as these digital assets rely on blockchains to exist. Transactions are verified by miners or validators (depending on the consensus mechanism used) and are permanently recorded on the blockchain.
On-chain transactions involve the use of cryptocurrency wallets and wallet addresses. For example, if you send Bitcoin to someone, both parties require a wallet so that the wallet address can be used to send the funds in the transaction. Every time a Bitcoin transaction occurs, the ledger is updated.
Everyone in a blockchain network can see the ledger that records transactions in the chain. This speaks for the openness of cryptocurrency as a whole. On-chain transactions are also very secure due to their presence on a blockchain.
However, on-chain cryptocurrency transactions take longer than the traditional transactions we perform in our lives, i.e. using your regular debit or credit card. This is because miners or validators must verify transactions on the chain. A transaction backlog occurs when a blockchain has a large load of transactions waiting to be verified, which can give way to long transaction times. No such problems exist for the Visa network, that’s for sure.
Today, as the cryptocurrency industry grows, many blockchains are dealing with longer transaction times, which can also give way to higher transaction fees. Many blockchains are not equipped to scale up to their growing popularity, which is known as a scalability problem. Bitcoin is a key example of a popular blockchain struggling to keep up with the transactional workload on the chain.
What is an off-chain transaction?
Again, as the name suggests, an off-chain transaction takes place outside of a blockchain. There are a number of ways that off-chain transactions can take place, and several advantages come with these types of transaction types.
A key element required by off-chain transactions is a third party. This third party can act as a guarantor, making a financial promise. Through the guarantor, the other party can be sure that the transaction is legitimate and will process. Alternatively, the confirmation can be guaranteed by sending the other party the private keys to a unique wallet, effectively transferring ownership to the other party.
In crypto, off-chain transactions are also known as second-layer protocols. These protocols have been developed to take some of the heat off the blockchains, which have to handle large parts of transactions on a daily basis.
Take the Lightning Network, for example. This second layer solution was developed to enable faster Bitcoin transactions by creating a private channel between two users to perform an off-chain transaction, in a private side channel. The Lightning Network can also lower transaction fees, which can sometimes be frustratingly high on the Bitcoin blockchain.
However, Lightning Network transactions are still recorded on the blockchain when the transaction is completed and the side channel is closed, even if the transaction takes place off-chain via a secure channel. It’s also worth noting that Lightning Network transactions are still visible on the blockchain ledger to everyone when they’re finalized, as is the case for a regular blockchain transaction.
The biggest difference is that off-chain transactions are usually far faster and less costly than on-chain transactions, which is why the Lightning Network is growing in popularity alongside other Ethereum layer 2 solutions. Off-chain transactions can also help reduce energy use, which can help reduce the environmental impact of crypto.
But there are some concerns about off-chain transactions. Take the Lightning Network again as an example. In the process of a Lightning transaction, funds can be stolen if one of the parties is malicious after the channel is closed. This involves the malicious party broadcasting the first transaction after the channel shutdown to recover the original funds they invested in the transaction.
Both on-chain and off-chain transactions have advantages and disadvantages
Obviously, on-chain and off-chain transactions have their uses in different scenarios and come with advantages and disadvantages. Either of these two transaction types may be better suited for you depending on how you use crypto and how you want your transactions to be handled.
