Off-Chain vs. On-Chain in Crypto: What's the Difference?

Everyone knows crypto transactions are slow. Could off-chain transaction be the solution?

If you're into crypto, you'll be familiar with blockchains. These ledgers form the backbone of the crypto industry and perform a variety of functions, including transaction processing.

But crypto transactions are not all one and the same and can be either on-chain or off-chain. But what exactly does this mean? What is the difference between on-chain and off-chain in crypto?

What Is an On-Chain Transaction?

As the name suggests, on-chain transactions take place on a blockchain. On-chain transactions are extremely common in crypto, as these digital assets rely on blockchains to exist. Transactions are verified by miners or validators (depending on the consensus mechanism used) and are permanently recorded on the blockchain.

On-chain transactions involve the use of cryptocurrency wallets and wallet addresses. For example, if you send Bitcoin to someone, both parties require a wallet so that the wallet address can be used to send the funds within the transaction. Every time a Bitcoin transaction occurs, the ledger is updated.

Anyone within a blockchain network can view the ledger that records on-chain transactions. This speaks to the transparency of cryptocurrency as a whole. On-chain transactions are also very secure due to their presence on a blockchain.

However, on-chain cryptocurrency transactions take longer than the traditional transactions we carry out in our lives, i.e., using your regular debit or credit card. This is because miners or validators must verify on-chain transactions. A transaction backlog is created when a blockchain has a large load of transactions waiting to be verified, which can give way to long transaction times. No such problems exist for the Visa network, that's for sure.

Today, as the cryptocurrency industry grows, many blockchains are dealing with longer transaction times, which can also give way to higher transaction fees. Many blockchains are not equipped to scale up to their growing popularity, which is known as a scalability issue. Bitcoin is a key example of a popular blockchain struggling to keep up with its on-chain transactional workload.

What Is an Off-Chain Transaction?

Again, as the name suggests, an off-chain transaction takes place outside a blockchain. There are a number of ways through which off-chain transactions can take place, and several advantages come with this kind of transaction type.

A key element required by off-chain transactions is a third party. This third party can act as a guarantor, providing a financial promise. Through the guarantor, the second party can be assured that the transaction is legitimate and will process. Alternatively, the confirmation can be guaranteed by sending the other party the private keys to a unique wallet, effectively transferring ownership to the other party.

In crypto, off-chain transactions are also known as second-layer protocols. These protocols are developed to take some heat off the blockchains that have to deal with huge swathes of transactions daily.

Take the Lightning Network, for example. This second-layer solution was developed to enable quicker Bitcoin transactions by creating a private channel between two users to conduct a transaction off-chain, in a private side-channel. The Lightning Network can also lower transaction fees, which can sometimes get frustratingly high on the Bitcoin blockchain.

However, Lightning Network transactions are still recorded on the blockchain once the transaction completes and the side-channel closes, even though the transaction takes place off-chain via a secure channel. It's also worth noting that Lightning Network transactions are still visible on the blockchain ledger to anyone once they've been finalized, as is the case for a regular blockchain transaction.

The biggest difference is that off-chain transactions are typically far quicker and less costly than on-chain transactions, which is why the Lightning Network is growing in popularity along with other Ethereum layer 2 solutions. Off-chain transactions can also help reduce energy usage, which can help in reducing the environmental effects of crypto.

But there are some concerns surrounding off-chain transactions. Take the Lightning Network again as an example. In the process of a Lightning transaction, funds could be stolen if one of the parties is malicious after the channel is closed. This involves the malicious party broadcasting the initial transaction after the channel closure to take back the initial funds they deposited in the transaction.

On-Chain and Off-Chain Transactions Both Come with Pros and Cons
Clearly, on-chain and off-chain transactions have their uses in different scenarios and come with advantages and disadvantages. Either of these two transaction types could be better suited to you depending on how you use your crypto and how you want your transactions to be dealt with.