How Does a Federated Sidechain Work?

Sidechains are one of the most fascinating and ambitious innovations in the Bitcoin space.

At their core, sidechains are parallel blockchains that enable interoperability via a two-way peg. They function in a state of cooperation and complementarity with the main chain they support.

As opposed to an altcoin blockchain, the sidechain doesn’t mine or stake its own cryptocurrency. Instead, it holds the same specifications for maximum supply and only transfers access to funds. The money that was available on the base layer will become only tradeable on the sidechain. As coins change hands on the sidechain, the return to the main chain will account for the correct ownership.

How Does the Two-Way Peg work?

For example, sending 1 BTC to the hypothetical X sidechain requires the coin to be locked in a script. The script generates little boxes for each transferred amount. Correspondingly, every box unlocks sidechain tokens (in our case, we’ll call them X-BTC).

While on this sidechain, the money can access features that the base layer doesn’t support. For instance, Bitcoin’s 10-minute validation can become speedier. Also, privacy-enhancing tools such as Confidential Transactions can receive integration by default. Furthermore, the transaction fees can see significant reductions due to the lower demand for block space. And last but not least, cross-blockchain trades (atomic swaps) can be made possible.

Decentralization and Efficiency

Interestingly, sidechains don’t require the same amount of decentralization as the main chain. As supportive blockchains that extend functionality, they can afford to experiment with governance. If something goes wrong with the sidechain, the stronger and more decentralized base layer won’t be affected. If anything, sidechains strengthen the network by offering an extra independent layer.

In some cases, federation setups consisting of big players with diverging interests can work well. Despite not being as decentralized as a Proof-of-Work blockchain, these federated sidechains are more efficient. They’re a terrible idea for base layer security and can’t compete with Bitcoin, but they are excellent for their purpose as sidechains.

Since sidechains don’t need mining thanks to their supportive financial policy, the only necessary process for security is validation. A group of functionaries must watch over the protocol rules, confirm valid transactions, and reject malevolent ones.

Seeing It In Action

Blockstream’s Liquid is the world’s first operational sidechain. Also, it’s the first project of its kind to experiment with a federative form of governance.

As a parallel blockchain, Liquid enhances Bitcoin’s scalability and confidentiality. As opposed to an altcoin blockchain, Liquid doesn’t compete against BTC with a proprietary coin or token. Instead, the protocol issues L-BTC on a 1-to-1 ratio for every bitcoin that is transferred. The two-way peg guarantees instant transferability, minimal friction, and no inflation.

Through Liquid, exchanges, and big traders can settle their transactions faster and cheaper. Also, the built-in Confidential Transactions are excellent for the privacy of sent amounts.

How Liquid Came To Be

In a BitcoinTalk post from February 2013, Bitcoin Core developer Peter Todd had introduced the concept of sidechains (which he referred to as “Fidelity-bonded banks”). At the time, he regarded the project as a viable scaling alternative for Bitcoin. Instead of increasing the block size, an interoperable blockchain would handle part of the transactions. In Todd’s view, off-chain payments are faster and more scalable than on-chain Bitcoin transactions.

The first formal exploration of the sidechain concept dates back to a research paper from October 2014. Titled “Enabling Blockchain Innovations with Pegged Sidechains”, the 25-page document is authored by an assembly of 9 Bitcoin Core developers: Adam Back, Gregory Maxwell, Pieter Wuille, Andrew Poelstra, Matt Corallo, Luke Dashjr, Mark Friedenbach, Andrew Miller, and Jorge Timon. The envisioned network enables interoperability between the Bitcoin blockchain and other sidechains.

Though the concept was very exciting at the time, the work on a functional proof of concept took almost four years. In the meantime, the Bitcoin scaling debate had come to an end. Unfortunately, the community was divided and big blockers could not see a deployed sidechain before migrating to other projects. Yet in the fall of 2018, sidechains saw a strong revival through Liquid.

The Liquid Federated Sidechain and Its Functionaries (Block Signers + Watchmen)

Four years after the research paper on pegged sidechains was published, Blockstream launched the Liquid federated sidechain. In the meantime, the Bitcoin start-up has developed a new framework for decentralized governance. Instead of relying on voluntary user participation like Bitcoin, Liquid uses a network of 34 exchanges, wallet providers, trading desks, and other Bitcoin service providers.

The governing functionaries are distributed in various geographical areas of the world. This significantly reduces the attack surface and increases censorship resistance. Single points of failure are bad for security, and therefore the Liquid federation stakeholders operate from a multiplicity of jurisdictions. It’s very unlikely for these governments to simultaneously coordinate network attacks, which is good news for security.

Furthermore, the odd number of 15 functionaries (the federation members that sign blocks) guarantees efficient decision-making. On one hand, it eliminates the possibility of inconvenient draws. On the other hand, it’s large and balanced enough to prevent the emergence of voting cartels (like in the case of EOS).

The Liquid functionaries, despite being on the same side and agreeing on the same rules, are actually competitors in the market. Decentralization is granted by the different incentives of every function. It’s in everyone’s best interest for the transactions to operate honestly and smoothly, but every member of the federation has to remain competitive and vigilant.

The geographically-diverse functionaries (Liquid side chain block signers) are: Altonomy, Bitbank, Bitfinex, Bitmax, BitMEX, Bitso, BTCBOX, BTCTrader/BtcTurk, BTSE, Cobo, Coinone, Coinut, Crypto Garage, DGroup, DMM Japan, FRNT Financial, Gate.io, GOPAX (operated by Streami), Huobi, L2B Global, OKCoin, OpenNode, Poolin, Prycto, Sideshift AI, The Rock Trading, SIX Digital Exchange, TaoTao, Tilde, Unocoin, Xapo, XBTO, and Zaif. Through their distribution, censorship resistance is maintained at all times and the protocol rules are better enforced.

The Liquid sidechain issues a new block every minute. And in order for a block to be added to the longest chain, it requires the signature of 2/3 of the block signers. If the network functions properly, then two consecutive blocks should guarantee transaction immutability. Therefore, it’s in the block signers’ best interest to remain vigilant.

A secondary duty of functionaries in the Liquid sidechain governance model is to serve as “watchmen”. This has to do with the responsibility of managing and securing Bitcoin held by the federation.

Whenever a peg-in to Liquid takes place, watchmen will make sure that at least 102 confirmations have been made on the Bitcoin blockchain. This might sound like a lot, but it safeguards the sidechain against main chain reorg attacks. The bitcoins that go on Liquid must be absolutely safe.

During peg-outs (BTC returning to the main chain), functionaries have an even more complex role. First of all, they process the transactions in batches and take 11 to 35 minutes to verify the inputs and outputs.

Secondly, functionaries have a list of Peg-out Authorization Keys (PAKs). This list is updated every 3 days to include all sidechain participants who are authorized to do peg-outs. Not on the list? You won’t be able to withdraw the BTC to the main chain. With that said, several exchanges and platforms allow you to trade and convert back to BTC through them.

These measures might sound a little draconian, but the Liquid sidechain is designed for security. It should not be a place where BTC gets lost, and it should provide its future by extending Bitcoin’s security.

The Advantages of the Liquid Sidechain

By transacting BTC on the Liquid sidechain, exchanges and traders get quicker confirmations and pay lower fees. During times when the Bitcoin block space is in great demand, this is a great advantage.

When making transactions, exchanges often opt-in for next-block confirmations. This means that they pay higher fees for their transactions to be processed faster. But on Liquid, they don’t have to worry as much about operation costs. Also, they benefit from quicker confirmations for settlements. And after the deal is settled, the coins can be moved back to the main chain at any time.

Furthermore, given the fact that exchanges use a large chunk of the block space with settlement trades, they can now help preserve it. This means that regular users will be able to make on-chain transactions at lower costs. And if specialized trade settlements move to sidechains or second layers, then 1 MB blocks will definitely scale.

Another great advantage of the Liquid federated sidechain is the inclusion of Confidential Transactions. Initially developed by Adam Back and Greg Maxwell for Blockstream’s Elements project, this cryptographic protocol increases sender privacy. In plain terms, only the receivers can see the amount of bitcoins that have been sent to them.

Moving Forward

In a sea of gimmicky altcoins that seldom solve real problems, being able to create useful Bitcoin tools without issuing proprietary tokens is a true blessing. Liquid delivers speed, scalability, and privacy without undermining Bitcoin’s security or value proposition. It’s the first extension of its kind and a pioneering invention for many brilliant cryptographic tools. In the future, it is likely we will see all desirable altcoin features become incorporated as Bitcoin sidechains or layers.