This article focuses on the Liquid Network and its implications for the Bitcoin ecosystem, but to understand more about the Liquid Network, we need to have an introduction to Layer 1 and Layer 2 solutions. In general, it should be said that the Liquid network is a side chain built on the Bitcoin blockchain, and the side chains are layer 2 networks. Stay with us until the end of the article to talk about Liquid Network, how it works and its benefits.
Layer 1 and 2 solutions
Although Bitcoin has become the most popular cryptocurrency in the world, several problems limit its widespread adoption. The biggest of these problems is Bitcoin’s minimal throughput (the Bitcoin blockchain can only process 5-7 transactions per second). To this end, centralized payment systems such as Visa can process thousands of transactions in the same time frame.
Bitcoin’s slow transaction speed discourages institutional investors, especially those involved in cryptocurrency arbitrage . Retail buyers may also find long transaction confirmation times counterproductive as it hurts liquidity and the user experience.
The transparent nature of Bitcoin creates more problems for large buyers. Anyone can see the balance of addresses and amounts related to Bitcoin transactions. This puts large orders at risk of going forward and raises privacy concerns for enterprise buyers.
Several solutions have been proposed to solve these problems, namely layer 1 and layer 2 solutions .
Layer 1 solutions require rewriting the blockchain protocol to implement changes such as larger block sizes or faster block times. While larger block sizes and faster block times may increase transaction speed , they tend to affect decentralization and network security. This is why the Bitcoin community rejected the SegWit2X proposal, leading to the hard fork that created Bitcoin Cash.
However, layer 2 solutions operate on top of the main blockchain without rewriting the network protocol. Layer 2 networks handle transactions outside the main chain, hence, they are also known as “off-chain” solutions. To maintain the security and immutability of transactions, off-chain transfers are made and added to the main chain.
Popular examples of layer 2 solutions developed for the Bitcoin blockchain include Rootstock, Lightning Network , and Liquid Network.
What is Liquid Network?
The Liquid network is a side chain built on the Bitcoin blockchain. Side chains are layer 2 networks that interact with the main chain through a “two-way peg”. Assets on a sidechain are linked to the value of the native assets they represent (1:1 ratio), allowing anyone to use their tokens and coins on another blockchain.
The Liquid Network is designed to provide fast, private and secure issuance, transfer and exchange of digital currencies, stablecoins, digital assets and security tokens on the Bitcoin blockchain. While Liquid Network works on top of the Bitcoin base layer, it operates independently and uses different methods to achieve higher throughput and more confidential transactions.
Liquid Network primarily serves institutional investors, exchanges , cryptocurrency traders and other institutional customers who want a higher level of privacy and faster transactions. Retail investors cannot use the Liquid network directly, unless they use the network through a member.
How does Liquid network work?
Basically, what Liquid Network does is issue a hashed version of BTC called L-BTC that can be used on its chain. To use the Liquid Network, users initiate a “peg-in”, which involves sending BTC to a Lightning Network address on the Bitcoin blockchain. When the transaction receives 102 confirmations, an equal amount of L-BTC is multiplied on the Liquid network and sent to the user’s address.
L-BTC holders are free to use this tokenized Bitcoin as they wish on the Liquid network. They may use it to trade on a Liquid-compatible exchange or buy digital assets and collectibles published on the chain.
If a user wants to withdraw their bitcoins, they initiate a “peg-out”, which starts by sending L-BTC to an unrecoverable address for burning . Once the transaction receives two separate confirmations, a member of the Lightning network sends the original Bitcoin to the user’s address on the Bitcoin blockchain.
Unlike Bitcoin, Liquid Network uses a different method to generate new blocks. Transactions are aggregated together into blocks and signed by 15 brokers of the Liquid network . These Functionaries run full nodes and are responsible for validating new transactions and broadcasting new blocks on the chain.
In addition, Liquid uses confidential transactions to increase the privacy of Bitcoin transactions. This feature hides key transaction details such as the amount transferred, the number of parties involved and the remaining balances in users’ addresses. However, network validation can still verify transaction amounts, total supply, and wallet balance.
Advantages of using the Liquid network
Liquid Network uses Signed Blocks, which reduce the time required to validate and process transactions. Unlike the 10 minutes it takes to add a block to the Bitcoin blockchain, new blocks are approved in about two minutes.
The Liquid Network’s faster transactions make it an ideal option for arbitrage traders who need to make quick cross-trades to make a profit. Bitcoin, with its long confirmation time, is not suitable for such people’s needs as trading benefits can be lost within minutes.
Retail investors who want to make faster transactions without converting their Bitcoins to risky altcoins can transact using L-BTC on supported exchanges. This means they can transfer and purchase assets without delay and still enjoy the security of the Bitcoin blockchain.
Satoshi Nakamoto , the inventor of Bitcoin, designed Bitcoin as a public ledger . This improves transparency as anyone can map transactions to individual addresses and even check wallet balances.
However, Bitcoin’s transparency can be confusing, especially for entities that handle large transactions. For example, a third party can use information obtained from transaction analysis to gain an advantage in the market, which is called frontrunning. The lead is detrimental to investors and discourages them from accepting Bitcoin.
Liquid Network implements confidential transactions to hide key transaction information from outsiders. This way, only the sending address, receiving address and transaction fee are recorded on the chain for transparency. The remaining details such as the type and amount of assets are visible only to the parties involved in the transaction.
Reduced transaction fees
A hidden benefit of the higher throughput of the Liquid network is the lower fees paid for transactions. When the Bitcoin network is clogged with unconfirmed transactions, miners are charged higher fees for prioritizing certain transactions. This has driven up Bitcoin transaction fees in the past, especially during bullish periods.
Liquid’s new consensus mechanism (block signature) increases transaction speed, so users don’t have to pay extra for fast transaction processing. Liquid Network’s low fees are ideal for retail and institutional investors who want to trade Bitcoin without using other blockchains. While new generation blockchains may promise lower transaction fees, they cannot offer the security and liquidity of Bitcoin.
Trustless Atomic Swaps
Atomic transactions provide a way for people to exchange cryptocurrencies without relying on an exchange or another trusted intermediary. Liquid users can perform trustless, peer-to-peer atomic swaps using the open source Liquid Swap tool .
For example, users can exchange tokenized versions of BTC (L-BTC) and USDT (L-USDT) on the Liquid network. This can create more liquidity for units and make it easier to trade Bitcoin with other assets.
Issuance of assets
Liquid Network facilitates the issuance of digital assets, which is impossible due to the limited functionality of Bitcoin. Users can issue, buy and exchange the following assets on Liquid: utility tokens, security tokens, stablecoins and digital collectibles ( NFT ).
Liquid network limitations
The Liquid network runs a federated system where 15 users are responsible for adding new transactions and maintaining the ledger. While this system reduces approval time, it is highly centralized and controlled by multiple parties.
Another concern is Liquid’s breakpoints. Bitcoin is difficult to close or hack because thousands of nodes (computers) maintain the network. Liquid relies on only 15 computer hubs, which increases the risk of censorship and malicious attacks.
Liquid Network vs. Lightning Network
Like Liquid, the Lightning Network is a Layer 2 network that operates on top of the Bitcoin blockchain. However, these off-chain solutions serve different purposes. While Lightning enables micro-bitcoin payments, Liquid focuses on transactions involving large amounts of bitcoin.
Lightning and Liquid also have different target users. Small businesses have found the Lightning Network payment channels very useful for processing Bitcoin payments. Conversely, companies such as financial institutions and cryptocurrency exchanges use Liquid to execute private and faster transactions.
Who controls the liquid network?
Liquid Network is the brainchild of Blockstream, a blockchain solutions company led by Adam Back, who developed Back Hashcash, inspired Bitcoin’s Proof-of-Work consensus , and was one of the few people Satoshi Nakamoto contacted while working on Bitcoin.
While Blockstream created Liquid, the network is managed by the Liquid Network Federation. Liquid Federation consists of 15 creditors (“employers”). Ordinary members who can vote on network updates and nodes who confirm network status.
While anyone can run a Liquid node and monitor the network, only 15 operators running full nodes can create new blocks. This position changes regularly among federation members to achieve a degree of decentralization.
Any member of the Liquid Network Federation (not necessarily an employee) can process peg-in and peg-out transactions. (BTC to L-BTC conversion) This requires federations to maintain pre-funded wallets on both Bitcoin and Liquid, so users can receive their locked or unlocked holdings quickly .
The Liquid Network has emerged as a popular solution for scaling the Bitcoin network and adapting it to enterprise needs. Liquid improves Bitcoin without changing the core protocol and gives users more functionality without compromising security.
Liquid also introduces programmability, tokenization and interoperability to Bitcoin. This may strengthen it against Ethereum , Solana, Cardano and other newer competitors and maintain its position as the leading blockchain in the world.