What is the Difference Between On-chain and Off-chain Transactions?

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In our current day-to-day transactions, there is immediate payment to sellers using cash methods, or delayed payment i.e. using a credit card. When it comes to crypto, transactions can also happen in two modes: on-chain and off-chain.

Understanding these terms is important for crypto users because they impact things like speed, security, and cost of your transactions. In this article, we break down the difference between on-chain and off-chain transactions as well as the pros and cons of each, so that you are able to make seamless crypto transactions every time, according to your priorities.

What are on-chain transactions?

On-chain transactions occur directly on the blockchain, the public ledger that records all crypto activity. When you buy crypto on an exchange and transfer it to your wallet, that’s typically on-chain. Here’s what you get with on-chain transactions:

• High security: Every transaction is verified and recorded by the entire network, making it tamper-proof.
• Transparency: Anyone can view all transactions on the blockchain, ensuring trust.

However, there are also downsides:

• Slower speeds: Since every transaction needs network validation, it can take time, especially for major blockchains like Bitcoin.
• Higher fees: Miners or validators who secure the network charge fees for their services.

What are off-chain transactions?

Off-chain transactions, on the other hand, take place outside the main blockchain. They might happen on secondary layers or through other channels. Here, you get:

• Faster speeds: Transactions can be near-instantaneous as they bypass the main network.
• Lower fees: Since there’s no mining or validation involved, fees are usually negligible.

However, there are trade-offs:

• Less secure: Transactions rely on trusted intermediaries or other mechanisms, which can introduce security risks.
• Less transparent: They’re not publicly recorded on the main blockchain, reducing overall transparency.

Analogy of an on-chain and off-chain transaction

Imagine you’re buying a car. Here’s how the on-chain and off-chain transactions would play out:

On-chain (Public registry):

• This is like going to the Department of Motor Vehicles (DMV) to register the car ownership change.
• You (seller) and your friend (buyer) both go to the DMV with the car title.
• The DMV official (miner) verifies all the paperwork (transaction details) and updates the official car registry (blockchain ledger).
• This process is secure (requires official verification) and transparent (anyone can check the registry).
• However, it can be slow (waiting in line at the DMV) and potentially involve fees (paid to the DMV).

Off-chain (Private agreement):

• This is like signing a bill of sale between you and your friend for the car.
• You both agree on the price and terms of the sale, writing them down and signing the document (similar to a smart contract).
• This can be faster (no waiting in line) and potentially cheaper (no DMV fees).
• However, it relies on trust between you and your friend (security of the agreement) and isn’t officially recorded (less transparent). There’s no central registry to verify the ownership change.

In essence, on-chain transactions are like public records, secure and transparent but potentially slow and costly. Off-chain transactions are like private agreements, faster and cheaper but rely on trust and lack the official record-keeping of the blockchain.

Knowing the difference between on-chain and off-chain transactions helps crypto users make informed decisions. For high-value transactions where security is crucial, on-chain might be preferred. But for everyday purchases or faster transfers, off-chain could be a better option.

For example, let’s say you’re transferring 0.5 BTC from one wallet to another. An on-chain transaction would be more apt in this case. However, if you’re buying a coffee from your friendly Bitcoin barista, an off-chain transaction might work better as it will incur less fees.

Making on-chain and off-chain transactions

Off-chain transactions for Bitcoin and Ethereum typically happen through third-party services, for Bitcoin this refers to Lightning Network or Liquid Network, and for Ethereum, this could be Polygon, Loopring, Optimism or various other L2 solutions.

As such, selecting between making an on or off-chain transaction simply means choosing a network to carry out your transaction. For Bitcoin, some popular Lightning-enabled wallets include Breez, Zap, Phoenix, Muun, Blue Wallet, or Wallet of Satoshi. You will observe that oftentimes, off-chain transactions offer faster settlement and lower fees compared to an on-chain Bitcoin transaction.

Similarly, for off-chain Ethereum transactions, look for DeFi wallets known for connecting to Decentralized Exchanges (DEXes) like MetaMask or Trust Wallet. This off-chain transaction will likely happen through the DEX’s smart contract system, potentially offering faster settlement and potentially lower fees compared to a direct on-chain swap on the Ethereum mainnet.

In conclusion

It’s important to note that this is not an exhaustive list, and new off-chain platforms are constantly emerging. Remember, when using any off-chain platform, it’s crucial to research its security and reputation before trusting them with your cryptocurrency. By understanding the difference between on-chain and off-chain transactions, you can explore using off-chain solutions for faster and potentially cheaper transactions within the Bitcoin, Ethereum or any other crypto ecosystems.