Why do we need Off-Chain and On-Chain transactions?

Everybody saw perfectly well what happens to Bitcoin and Ether during heavy loads: processing time and transaction price increase dramatically.

How to solve this problem?

Spoiler: there is no simple solution.

If you just increase the speed of transactions and decrease their cost, the decentralization and reliability of the blockchain will suffer a lot.

Because of cheap transactions, the network is easy to attack, and to increase throughput, you have to increase the hardware requirements to run the blockchain nodes that process transactions and synchronize the blockchain.

The higher the requirements on the computers of the network participants, the less decentralization. For blockchain, it is very important that ordinary users can afford the equipment to support the network and process transactions – this increases decentralization.

On-chain transactions are standard transactions that take place inside the blockchain. They are checked by miners or validators and written to the blockchain. On-chain transactions have maximum security, but because of this the speed of processing suffers.

Off-chain transactions are transactions that are processed off the blockchain and help offload the network. They allow for more confidential, cheaper and faster transactions without seriously compromising blockchain security. Even though off-chain transactions take place off the blockchain, they still write the final data to the main blockchain.

Examples of off-chain protocols for Bitcoin and Ether are Lightning Network (BTC), Liquid Network (BTC), Optimistic (ETH), Arbitrum (ETH) and other Layer 2 networks.

Each of them has its pros and cons. For example, Optimistic and Arbitrum lower the entry threshold to the Ethereum ecosystem, but they are too complicated for ordinary users to understand. And Lightning Network, for example, enables instant and almost free Bitcoin transactions, but it’s only useful for micropayments.

There is no perfect way to scale, you always have to sacrifice something. Ethereum 2.0 is the closest thing to a balance of decentralization and scaling, but it is still a long way from release.

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