The Blockstream guys – the ones working on a commercial application of the Lightning Network I told you about the other day – have announced the upcoming launch of Liquid, the first commercial application of the sidechain concept. This is exciting, as sidechains have been talked about for a while now, but have yet to be put to practical use. And the use of Liquid is indeed practical: it will help bitcoin exchanges improve their service and reduce their risk, with faster settlement and lower costs. Before we go into why this is important, let’s take a look at the background.
First, what are sidechains?
Sidechains are effectively private blockchains, linked to the public Bitcoin system. They use the transmission and custodian power of Bitcoin – information stored in a tamper-proof block – while enjoying greater speed and lower cost. The idea is that an amount of bitcoin could enter a sidechain, the participants can trade that bitcoin amongst themselves as many times as necessary before sending the new distribution back to the Bitcoin blockchain for settlement. The transactions on the sidechain are governed by the sidechain’s rules, which can be anything the administrators want them to be. The only stipulation is that the same amount of bitcoin that goes in needs to come out, although obviously the ownership of those bitcoins will be different.
Second, what are bitcoin exchanges?
A bitcoin exchange will sell you bitcoin in exchange for a fiat currency, such as dollars or euros or whatever you use on a day-to-day basis. They will also buy your bitcoins in exchange for a fiat currency. One of the main frustrations of the exchanges has been the latency of bitcoin transactions, that is, the time they take to settle. It’s much faster than traditional transactions, but it is still not instantaneous, and an exchange’s business needs to be instantaneous.
A brief review of the technology: once a bitcoin transaction is validated by the network, it is included in a block of other transactions, processed by the miners, and added to the blockchain. A block is processed and added to the chain every 10 minutes or so. This is actually an artificial amount of time, chosen to limit the amount of new bitcoin entering the system. Every time a block is processed and added to the chain, the miner who does so gets rewarded with new bitcoins. Processing each block involves computing a cryptographic hash, which is set at a level of difficulty that takes about 10 minutes to calculate. That was deemed enough time to keep the system efficient while restricting the entry of new bitcoins to a trickle instead of a flood.
Each block contains a coded reference to the previous block. If the previous block is tampered with, that coded reference is no longer valid, which makes the whole block invalid. So, to tamper with a block, you would also have to change the coded reference in the block that comes next. That is very difficult to do. And if there are not just one but six blocks that come after, it’s virtually impossible, as you would have to re-configure and validate all the posterior blocks, which would take an unimaginable amount of computing power. So, the standard is that, to be absolutely sure of a transaction’s validity, you should wait until it has 6 blocks on top of it. Given that each block takes about 10 minutes to process, that is a settlement time of about 1 hour.
Because exchange customers don’t want to wait an hour for confirmation of their trade, the exchanges need to keep on hand a pretty big balance of bitcoin and fiat currencies to cover the trade until it is technically secure. Part of the cost of the necessary capital requirement, as well as the risk the exchanges incur in trusting that the trade will settle correctly, can be seen in the exchanges’ commissions and/or spreads. If the capital requirement is reduced, trades can become cheaper.
How will Liquid help?
Each participant of Liquid will maintain a node, that is, it will be responsible for verifying the cryptography on the trades on its exchange. Because no new bitcoins will be entering the system, the artificial 10 minute lag time is unnecessary. Transactions will still be grouped into blocks, which will still be added onto previous blocks, but it will happen almost instantaneously. This way, bitcoins and other currencies can flow between accounts of the participating exchanges much faster than at present, which will reduce the capital requirements and the operating costs. Several of the big exchanges – Bitfinex, BTCC, Kraken, Unocoin, and Xapo – have already signed up, and it’s likely that more will follow.
Why is this important?
This development looks like it will remove some of the Bitcoin inefficiencies (speed, energy cost) while maintaining the advantages (decentralization, security), and should enhance the attractiveness and liquidity of the digital currency. That will have ripple effects throughout the sector and beyond, as the pool of participants and users grows.
Also important is the innovation that this is likely to encourage. Several of the founders of Blockstream authored, along with other collaborators, a white paper back in October 2014, discussing the sidechain concept and its potential uses. The paper is open-source, and the authors encourage other developers to experiment with the idea. The development of sidechains allows Bitcoin experimentation, such as the inclusion of new features, the use case for new assets, even new cryptography. Previously, this kind of experimenting had to be done with altcoins, which are Bitcoin alternatives, separate currencies using the same or a similar technology. A system that only allows experimentation through competition is weaker than one that encourages it “in house”.
Sidechain implementation will require a soft fork (a change in the Bitcoin protocol which will not affect trades using the old protocol), which takes time. This is probably why the launch of Liquid was announced yesterday, but will not be implemented until the first quarter of 2016. Apparently a white paper is forthcoming which will explain in detail how Liquid works. This is likely to breed a flurry of other use cases, which will further increase Bitcoin’s usefulness and applicability. These are interesting times, with change happening fast. And with Liquid, it could be time to pour another cup.