Blockchain technology can be used to facilitate cryptocurrency transactions without the need for a trusted third party like a bank. “On-chain” transactions carried out on a blockchain offer greater security and transparency, becausse they’re verified and recorded on a public distributed ledger that cannot be changed.
Off-chain transactions are confirmed outside of the main blockchain network, often resulting in a cheaper and faster process for the user.
Here are the differences between on-chain and off-chain transactions and when they're both used.
What are on-chain transactions?
On-chain transactions refer to a transaction that is carried out on a blockchain network from start to finish. Once verified, the transaction is recorded on a blockchain network’s public ledger.
Here’s how it works: When two parties want to trade cryptocurrency, information about the transaction is packaged and time-stamped on a digital collection of data called a block. That block is sent to an associated blockchain network where it waits to be validated by computers in the network called nodes and added to the blockchain.
There are different consensus mechanisms used to verify transactions and add new blocks to a blockchain. Bitcoin, for example, uses a method called proof-of-work, which rewards miners for competing against each other using specialized computer software to solve extremely difficult computational puzzles to guess or match the “hash” and win the block reward. Newer methods like proof-of-stake don’t require mining computations but require participants to lock up a set amount of the native crypto token – their “stake” – to have a chance to be the validator for a block of transactions.
Either process provides a high level of security and transparency because transaction data is public and constantly reviewed and updated by the network of miners or validators. However, the intricacy of the process means that it takes some time to process each transaction and add it to the blockchain.
Benefits of on-chain transactions include:
- Security: Data stored on a blockchain is encrypted end to end and cannot be altered once recorded.
- Decentralization: Blockchains are not subject to a central authority for governance, which means there’s virtually no risk of an intermediary breaching trust or manipulating data flow.
- Transparency: The use of a distributed ledger means transactions are simultaneously recorded and validated in multiple locations. Using a blockchain explorer, anyone can trace a transaction back to a unique wallet address and view its activity, allowing independent verification of claims and transactions.
Disadvantages of on-chain transactions include:
- Slow transactions: The speed of a blockchain transaction can vary depending on the volume of transactions in the queue to be processed, which can lead to network congestion.
- High transaction fees: When the volume of transactions is high, network fees also rise. During times of high demand, the network can become extremely expensive to use.
- Power usage: Specific to proof-of-work consensus mechanisms, the mining process uses a large amount of computational power and energy.
What are off-chain transactions?
In contrast, off-chain transactions transfer some of the work from a blockchain ecosystem, which can later be integrated back into a blockchain. On an off-chain network, the users agree that a third party will handle validating and authenticating transactions.
Off-chain systems tackle a blockchain network's scalability issues by facilitating faster and cheaper transactions. One off-chain transaction method is to employ a layer 2, which is a second blockchain built on top of the main blockchain (mainnet) to help the mainnet scale in speed and cost. This takes transactions off the main chain to another chain, but for the purposes of this explainer, we’ll focus on other off-chain methods.
Off-chain transactions can be confirmed via:
- A transfer agreement between two parties
- Using a third party known as a guarantor to oversee the transaction, like PayPal (PYPL)
- Sending another party the private keys to a wallet, which keeps the value of the cryptocurrency inside the wallet while transferring ownership over the wallet to someone else
Benefits of off-chain systems:
- Faster transaction speeds: Off-chain transactions don’t have to wait for the main blockchain network to confirm a transaction, making it faster or even instantaneous to process.
- Lower cost: Transactions confirmed off-chain require little-to-no fees because the process of validation through mining or staking isn’t needed. This feature is especially useful in handling large sums of cryptocurrency.
- Greater anonymity: Off-chain transactions offer more privacy because the data is not being publicly broadcast to the network.
Disadvantages of off-chain methods vary by method but can include:
- Less transparency: Transactions that occur off-chain do not follow the same protocol as a blockchain, opening up more potential for disputes.
- No consensus method: Without a consensus among all the users on the network, validation and authentication may be left to an intermediary. This means trust needs to be given to this third party instead of allowing all the network participants to agree as a collective.
- Can be less secure: Blocks added to a blockchain cannot be altered, so operating outside of the blockchain makes a network more vulnerable to fraudulent activity.
Blockchain networks provide security, transparency and ease of use when conducting a transaction. Still, some blockchain networks such as Bitcoin or Ethereum remain limited in their scalability and sometimes require high fees to process transactions. Off-chain systems address these issues and promote faster processing speeds, lower fees and greater discretion.