If you love crypto, you will be familiar with blockchains. These ledgers form the backbone of the crypto industry and perform various functions, including transaction processing.
But not all crypto transactions are the same and can be on-chain or off-chain. But what does that mean exactly? What is the difference between on-chain and off-chain in crypto?
What is a chain transaction?
As the name suggests, on-chain transactions take place on a blockchain. On-chain transactions are extremely common in crypto because these digital assets depend 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 Bitcoins to someone, both parties need a wallet so that the wallet address can be used to send the funds as part of the transaction. Each time a Bitcoin transaction occurs, the ledger is updated.
Anyone within a blockchain network can view the ledger that records on-chain transactions. This speaks to the transparency 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 do in our lives, i.e. using your usual 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 awaiting verification, which can cause long transaction delays. No such problem exists for the Visa network, that’s for sure.
Today, as the cryptocurrency industry grows, many blockchains are facing longer transaction times, which can also lead to higher transaction fees. Many blockchains are not equipped to accommodate their growing popularity, known as the scalability problem. Bitcoin is a key example of a popular blockchain that struggles to keep up with its on-chain transactional workload.
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 in which off-chain transactions can take place, and several advantages come with 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 be processed. Alternatively, confirmation can be guaranteed by sending the other party the private keys to a single wallet, thereby transferring ownership to the other party.
In crypto, off-chain transactions are also called second layer protocols. These protocols are developed to take some of the pressure off blockchains that have to handle huge amounts 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 reduce transaction fees, which can sometimes become frustrating on the Bitcoin blockchain.
However, Lightning Network transactions are still recorded on the blockchain after the transaction is completed and the side channel is closed, even if the transaction takes place off-chain through a secure channel. It should also be noted that Lightning Network transactions are still visible on the blockchain ledger to anyone once they have been finalized, just like a regular blockchain transaction.
The biggest difference is that off-chain transactions are generally much faster and cheaper than on-chain transactions, which is why the Lightning Network is gaining popularity with other Ethereum layer 2 solutions. Off-chain transactions can also help reduce power consumption, which can help reduce the environmental effects of cryptography.
But there are some concerns about off-chain transactions. Take the Lightning Network again as an example. In a Lightning transaction, funds could be stolen if either party is malicious after the channel is closed. This involves the malicious party broadcasting the initial transaction after the channel is closed to recover the initial funds they deposited 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 have advantages and disadvantages. Either of these two types of transactions might suit you better depending on how you use your crypto and how you want your transactions to be processed.