Bitcoin was designed to be a decentralized and trustless payment network – with the power to do this provided by the block chain and its ability to publicly confirm the digital currency's digital transactions.
Rather contentiously, however, as the bitcoin economy expands, more and more transactions are being carried out off the block chain.
Such transactions are tracked on private databases instead of the block chain, and cannot be publicly tracked.
There are pros and cons to both systems. So, which are better? Off-block chain or on-block chain transactions?
Legitimate use cases for on-block chain transactions include those that must be shown publicly for particular reasons, such as to facilitate larger payments.
Many users might not mind smaller transactions off the block chain, but bigger transactions can receive public verification with bitcoin's general ledger. So, on-chain is insurance of sorts – proof that a payment exchange between parties did happen.
Marcell Ortutay is the developer of Coinwall, which relays bitcoin microtransactions on the block chain for the purpose of paywalls for online content. He said that, in light of nefarious actors in the cryptocurrency space, on-block chain transactions are a better verifier of sorts:
"When you use a hosted wallet, you partly lose the digital currency aspect, since you no longer have bitcoins, just promises of bitcoins."
Perhaps the most noteworthy example of a hosted wallet gone awry would be Mt. Gox. Despite all the warning signs of that exchange's mismanagement, Ortutay points out people still had faith in the Tokyo-based company:
"As the Mt. Gox situation shows, people are happy to keep their bitcoins on the most untrustworthy hosted wallets out there."
Need for speed
These companies are facilitators of everyday payments between parties and, as a result, they have decided to keep transaction speeds high by keeping most payments internal – that is, off the the public block chain.
Scott Robinson runs bitcoin initiatives at the Plug and Play startup accelerator, which has headquarters in Sunnyvale, California. He says this issue is a factious subject within the community:
"Off-chain transactions are a divisive concept, obviously. Defeating the purpose of the open ledger aspect to the protocol is a concern."
Robinson says that at Plug and Play's cafeteria there is a bitcoin-accepting point of sale (POS) system, and he has seen why companies like Coinbase want to run transactions through their own system, off-chain.
Simply, it's faster to use Coinbase-to-Coinbase, for example, than relying on Coinbase-to-block chain. Plus, "issues arise with miner fees," Robinson noted.
Transaction off the block chain do not incur the small amount of BTC that miners are paid for their services in verifying the ledger. Hence, transaction are a little more expensive on-chain.
Robinson believes the issues with transaction speeds on-chain need to be worked out, and suggests doing so with trial-by-fire:
"I would say I'm in the camp of putting as many transactions on the network as possible and working to solve the micro-transaction latency issue."
There is another reason why companies use their own database systems to move bitcoin around: the potential scaling problems that could result as transactions on the bitcoin network increase.
Blocks are only being generated every 10 minutes, which makes confirmation a major issue.
That's why, for larger transactions, bitcoin on-chain makes sense, but less so for smaller payments, which are more often regular and frequent.
The bitcoin network, as it is currently, just cannot support thousands of transactions per second like traditional payment systems. Therefore, there is a strong incentive for companies to go off-block chain instead.
There are some proposals that could help give bitcoin a speed boost, however.
Perhaps the most intriguing of these would involve a more trustless system by implementing payment channels in a hub-and-spoke design. This is one theoretical way to counter the problems with transaction and block chain size growth.
Catheryne Nicholson, co-founder of BlockCypher, a cloud-based block chain service provider, thinks that bitcoin's infrastructure needs to be performance optimized.
BlockCypher, as a result, is building scalable solutions to help keep the system on-chain, she said, adding:
"There's no reason for off-blockchain transactions to exist. It undermines the entire block chain."
Jesse Powell, the CEO of cryptocurrency exchange Kraken, said that his company uses on-block chain transactions. "We operate under the presumption that, when you are sending money out, you’re withdrawing. It’s to your own wallet."
The reasoning behind that is purely for regulatory reasons, he explained. Off-block chain movement of cyrptocurrency, in Kraken's view, has compliance issues:
"Legally, [off-chain] would be different. It would be money transmission. Coinbase is doing money transmission. So we’re trying to avoid money transmission until we have licences."
Ortutay, the on-chain micropayment entrepreneur, thinks that some bitcoin companies may have other, less desirable reasons to transact off-block chain:
"Exchanges use off-chain so they can run a fractional reserve. Certain (unnamed) exchanges/brokers do this because it's hard to operate otherwise."
Many in the bitcoin community realise that off-chain is quickly increasing in popularity. The problem, however, is that bitcoin stands to lose a portion of one of its key benefits – its decentralized nature.
Ortutay believes that that could, in the end, deliver a blow to bitcoin's early adoption. Bitcoin as a payment mechanism may face a marketing problem when it appears to be doing the same thing its competitors are, he explained, saying:
"People will correctly question what is so amazing about bitcoin if it is doing the same thing that PayPal or Google Wallet does."
Bitcoin chain image via Shutterstock