If you are into cryptocurrencies, you will be familiar with blockchains. These ledgers form the backbone of the cryptocurrency industry and perform a variety of functions, including transaction processing.
But crypto transactions are not all the same and can be both on-chain and off-chain. But what exactly does that mean? What is the difference between on-chain and off-chain in crypto?
What is an on-chain transaction?
As the name suggests, on-chain transactions take place on a blockchain. Chain transactions are extremely common in cryptocurrencies, 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 are sending Bitcoin to someone, both parties require a wallet so that the wallet address can be used to send the funds within the transaction. Whenever a Bitcoin transaction occurs, the ledger is updated.
Anyone within a blockchain network can view the ledger that records the transactions on the chain. This speaks to the transparency of the cryptocurrency as a whole. On-chain transactions are also very secure thanks to their presence on a blockchain.
However, on-chain cryptocurrency transactions take longer than traditional transactions we perform in our life, such as using your regular debit or credit card. This is because miners or validators need to verify on-chain transactions. A transaction backlog is created when a blockchain has a large load of transactions waiting to be verified, which can give way to long transaction times. There are no such problems for the Visa network, that’s for sure.
Today, with the growth of the cryptocurrency industry, many blockchains are dealing with longer transaction times, which can also give way to higher transaction fees. Many blockchains are not equipped to increase their growing popularity, known as the scalability problem. Bitcoin is a key example of a popular blockchain struggling to keep up with its chain transactional workload.
What is an off-chain transaction?
Again, as the name suggests, an off-chain transaction occurs outside of a blockchain. There are several ways in which off-chain transactions can occur, and several benefits come from this type of transaction.
A key element required by off-chain transactions is a third party. This third party can act as a guarantor, providing a financial promise. Through the guarantor, the second party can be assured that the transaction is legitimate and will process. Alternatively, confirmation can be guaranteed by sending the private keys to a single wallet to the other party, effectively transferring ownership to the other party.
In crypto, off-chain transactions are also known as second-level protocols. These protocols are developed to take some of the heat out of blockchains that face huge amounts of transactions every day.
Take Lightning Network, for example. This second tier solution was developed to enable faster Bitcoin transactions by creating a private channel between two users to conduct an off-chain transaction, in a private side channel. Lightning Network can also reduce transaction fees, which can sometimes become frustrating on the Bitcoin blockchain.
However, Lightning Network transactions are still recorded on the blockchain once the transaction is complete and the side channel is closed, even if the transaction occurs off-chain via a secure channel. It is also worth noting that Lightning Network transactions are still visible to anyone on the blockchain ledger once they have been finalized, as is the case with a normal blockchain transaction.
The biggest difference is that off-chain transactions are typically much faster and cheaper than on-chain transactions, which is why Lightning Network is becoming more and more popular alongside other Ethereum Tier 2 solutions. Off-chain transactions can also help reduce energy consumption, which can help reduce the environmental effects of cryptocurrencies.
But there are some concerns about off-chain transactions. Take Lightning Network as an example again. In the process of a Lightning transaction, funds could be stolen if either party is malicious after the channel is closed. This implies that the attacker transmits the initial transaction after the channel is closed to get back the initial funds deposited in the transaction.
Both on-chain and off-chain transactions have advantages and disadvantages
Clearly, on-chain and off-chain transactions have their uses in different scenarios and have advantages and disadvantages. Either of these two transaction types may be more suitable for you depending on how you use your cryptocurrency and how you want your transactions to be handled.