Bitcoin: On-Chain vs Off-Chain Transactions

This page looks into the differences between on-chain (Mainnet) and off-chain (Lightning Network) Bitcoin transactions.

Overview

The purpose of this document is to provide an overview of Bitcoin network transaction types to help BlockSpaces users understand their appropriate use cases. When making payments on the Bitcoin Network, the user has the option to choose either the Bitcoin blockchain (on-chain) or the Lightning Network (off-chain). Each option has its own unique characteristics that make them better suited for different situations.

Please note: While this document is beginner-friendly, it only discusses Bitcoin transactions from a BlockSpaces user experience perspective. Deeper protocol-level knowledge can be found at bitcoin.org and Lightning Network .

On-Chain Transactions

A transaction performed on the Bitcoin blockchain is known as an “on-chain transaction”. These transactions are “pushed” from one Bitcoin wallet to another, meaning the payments are initiated by the sender of the funds. Once a transaction is sent, it enters a virtual “waiting room” of unconfirmed transactions known as the “mempool.” In (typically) under one hour, the transaction is confirmed and recorded on the Bitcoin blockchain in a process called “mining”. Once mined, a Bitcoin transaction is complete and not reversible. On-chain transactions are reliable, secure, and do not require any trust between participants.

Use Cases

Being a global peer-to-peer electronic cash system, some of Bitcoin’s primary business use cases are in cross-border payments and large transactions in general. Bitcoin transactions do not need banks, currency exchanges, or other middlemen to complete so they settle at a fraction of the speed of global fiat transactions, and for lower fees. Given the open nature of the Bitcoin blockchain, transaction histories are easily accessible on block explorer websites for logging purposes.

Challenges

The innovativeness of Bitcoin comes with certain challenges that should be taken into account before sending a transaction. First, the Bitcoin blockchain typically takes up to a half hour (or more!) to process a transaction. This is far too long for face-to-face transactions such as retail stores. Secondly, transaction fees are often prohibitive for small transactions like those in fast food restaurants. An on-chain transaction for a cup of coffee can cost almost as much as the drink itself. The Lightning Network enables off-chain Bitcoin transactions in order to solve these problems

Off-Chain Transactions (Lightning Network)

A Bitcoin transaction performed over the Lightning Network is also known as an off-chain transaction. The Lightning Network may be best viewed as a second layer of the Bitcoin network “above” the main blockchain. Off-chain transactions settle near-instantly and incur a tiny fraction of the fees experienced with an on-chain transaction. An on-chain transaction is required in order to onboard bitcoin into the Lightning Network. Because the transactions that fund the Lightning Network are on-chain, all bitcoin on the Lightning Network enjoys the same security and immutability as on-chain transactions. Remember: on-chain transactions are recorded on the blockchain and cannot be edited, manipulated, or reversed. Therefore, the on-chain transactions that fund the Lightning Network have been given a final confirmation from the bitcoin blockchain as real bitcoin.

Off-chain transactions work a little differently than on-chain transactions. Rather than senders “pushing” transactions to receivers, the Lightning Network works by “pulling” transactions from senders using invoices. Invoices are long strings of text encoding the receiving wallet, the amount of bitcoin being requested, and other information required for the transaction to be successful. QR codes are typically used along side invoice numbers, enabling smart phone cameras to initiate transactions easily.

Check out this Medium article for more information on Lightning Network invoices.

Use Cases

Off-chain transactions create a near-instant, low-fee environment for small transactions. For a business, this means virtually eliminating transaction fees charged by payment processors. For consumers, it means tiny fees for transactions and no waiting for transactions to confirm. Off-chain transactions via the Lightning Network are preferable to on-chain transactions in the face-to-face payment scenarios mentioned above. Paying for that cup of coffee with Bitcoin just became much more attractive!

Challenges

Off-chain transactions are superior to on-chain transactions in many ways, but have some unique limitations that on-chain transactions do not have.

The first limitation is that of liquidity; one cannot send or receive more Bitcoin than what exists in their inbound and outbound channels. Furthermore, liquidity is depleted by sending and receiving payments, creating a need to re-balance payment channels. To learn more about payment channels and liquidity, please see our documentation on Lightning Network Channels and Liquidity.

The other challenge with off-chain transactions is a business-centric problem: logging and accounting transactions. There is no simple way to record and log transactions without first setting up and maintaining a full Bitcoin node, installing the Lightning Network software, and handling all the channel and liquidity pieces mentioned in the above paragraph.

BlockSpaces has solved for these challenges for businesses by offering Bitcoin Invoicing & Payments; consisting of a non-custodial Lightning Network node, worry-free liquidity & channel management, and easy integration with Quickbooks.