Blockstream’s Bitcoin sidechain solution, Liquid, slated for launch in early 2018

Sidechains promise to help Bitcoin adapt to new demands and accommodate new innovation, according to the company behind the seminal sidechain whitepaper, Blockstream. Several different companies have been developing the idea since Blockstream introduced the concept in an October 2014.

“We propose a new technology, pegged sidechains, which enables bitcoins and other ledger assets to be transferred between multiple blockchains,” states Blockstream in the paper, Enabling Blockchain Innovations with Pegged Sidechains. ”This gives users access to new and innovative cryptocurrency systems using the assets they already own.”

Blockstream describes sidechains as blockchains that allow users to transfer assets to and from other blockchains. As sidechains are fully-independent chains, they are able to implement a variety of different features, such as block structure or transaction chaining. The whitepaper posits that by reusing Bitcoin’s currency, these systems can more easily interoperate with each other and with Bitcoin, avoiding the liquidity shortages and market fluctuations associated with new currencies.

The key to blockchain interoperability is the transfer of assets, known as the “two-way peg.” The peg works by locking the assets in a transaction on one chain, making them unusable there, and then creating a transaction on the sidechain that describes the locked asset. Effectively, this moves assets from a parent chain to a sidechain.

One of the fundamental roadblocks in deploying sidechains is that the Bitcoin blockchain is not currently capable of executing the required verification rules for a two-way peg. Blockstream describes changing the protocol as “non-trivial,” and the process of implementing similar changes was part of the motivation for pegged sidechains to begin with.

However, Blockstream postulated that it is possible to do an initial deployment in a completely permissionless way, using a two-way peg described as a “federated peg”. In January 2017, Blockstream released a second paper, Strong Federations: An Interoperable Blockchain Solution to Centralized Third-Party Risks. The document expands on the federated peg, and introduces a detailed version called Strong Federation, while describing a Strong Federation sidechain implementation called Liquid, “the first market implementation of the system.”

“With Liquid in place, we believe Bitcoin will be in a stronger position to attract institutional trading firms and brokerages, as well as address global liquidity and pricing data challenges faced by these players interested in bitcoin as an asset class. That will be a major milestone for Bitcoin, bringing many new users and applications to the industry.”
— – Samson Mow, Blockstream Chief Strategy Officer

The company states that leveraging proof-of-work provides Bitcoin with unprecedented security for transaction history, which “comes at a cost in latency and throughput.” Liquid addresses the delay by introducing a set of participants with two responsibilities: generating valid blocks and enforcing withdrawal rules. “This coordination is measured in seconds as opposed to minutes for Bitcoin,” the company claims. “As in Bitcoin, the knowledge of a private key is sufficient for the ‘right to spend’ without the permission of any third party.”

The Liquid network is made up of a federation of operators, or functionaries. These network operators mechanically execute defined operations if specific conditions are met. Functionaries have the power to control the transfer of assets between blockchains and to enforce the consensus rules of the sidechain.

The platform has been in testing with a number of Bitcoin companies since early April, and is slated for a public launch in Q1 of 2018, no matter if SegWit is adopted or not. The first version, v1.0, supports up to 15 functionaries, “each securely hosted by geographically dispersed, independently owned and operated bitcoin exchanges,” Blockstream Director of Product, Ben Gorlick, told Brave New Coin. “Several can go down without impairing the system’s ability to operate, and even if the system stops operating, there are multiple recovery systems for ensuring that customer funds are not lost.”

“There are no Blockstream-run servers required for the day-to-day running of Liquid, the servers running the Liquid network are hosted by the participating exchanges.”
— – Ben Gorlick, Blockstream Director of Product

Gorlick states that the platform will “facilitate trading, arbitrage, and liquidity amongst participating exchanges – hence the name Liquid.” A possible side-effect is an indirect decrease in Bitcoin’s existing traffic. “Liquid does help with scaling in that it can reduce pressure on the Bitcoin blockchain if traders choose to keep a balance of bitcoin on the Liquid network,” Gorlick explains, “and if those traders use the Liquid network for high volumes of transfers between exchanges.”

The major customer-facing innovation is a wallet that customers can use to securely hold their liquid bitcoins, off of the exchanges, but in a way that allows them to move those coins very quickly when needed. “Liquid provides a more secure and efficient system for exchange-side bitcoin to move across the network,” adds Chief Strategy Officer, Samson Mow.

Another feature makes use of the TOR privacy-routing network. There are at least three types of transactions users can make using TOR, according to Mow, with each Liquid address starting with the letter X if confidential, and Q or H otherwise: “The expectation is that the majority of usage will be confidential, and that is the default.”

Gorlick adds that institutional traders and Wall Street firms may want to move bitcoin between their accounts at different exchanges, “without broadcasting the amounts to the general public, providing assurances that their trading strategies and holdings are not exploited by potential adversaries.”

“Like Bitcoin, Liquid transactions are viewable by everyone in the network, so Confidential Transactions hides transaction amounts from everyone except for the parties directly involved in the transaction itself. In doing so, it minimizes front-running risks that occur through blockchain analysis.”
— – Ben Gorlick, Blockstream Director of Product

The limitations mostly fall on the shoulders of the federation members. Since they are responsible for transferring bitcoins into and out of the Liquid network. They’ll also be paying the bitcoin transaction fee and the Liquid transaction fee for each use, according to Glenn Willen, the Liquid Engineering Team Lead. The round-trip time of going from Bitcoin to the sidechain and back will be “about a day,” which he stresses is “not something that end users need to do, as these activities are performed by the Liquid functionaries.”

There are size constraints as well. The maximum size of confidential transactions is planned to be nearly 700 BTC in the production Liquid network, Willen divulged, although the size of regular (non-confidential) transactions is not limited in any way. “We expect almost all transactions to be confidential,” he added. Meanwhile, there is no minimum size restriction, but the team acknowledges that Liquid will not be cost effective for small payments, including a cup of coffee. “For merchants and micropayments, it would probably better to use Lightning instead of Liquid,” Mow explains.

Other sidechain projects in the space have been designed to fill other niche needs, and Mow doesn’t view them as competing products. “Rootstock and Drivechain utilize the two-way peg invented by Blockstream,” Mow states, while “all three leverage sidechain technologies to move asset value between different blockchains.” A link to the RSK project is prominent on the sidechains page of Blockstream’s website. However, the three “approach implementation of that functionality in different ways.”

“Liquid is much further along as it’s a production-grade sidechain, having been peer-reviewed, alpha and beta tested for over a year by end users,” Mow states, “and its codebase has been audited by an independent security firm.”