What is the Liquid Sidechain?
Liquid – One of the Original Bitcoin Sidechains
Liquid is one of the first Bitcoin sidechains that was launched by Blockstream at the end of 2018. Blockstream is a for-profit company based in Canada and was founded by Adam Back, a notorious cryptographer and Cypherpunk, whose work was cited in the Bitcoin whitepaper. Although Blockstream is usually associated with Liquid, the company has no control over the sidechain network and only serves as a technology provider. The Liquid Network is ultimately governed by a federation of different parties and operated on an open-source software platform called Elements.
What is Liquid?
As said, Liquid is a Bitcoin sidechain. Figuratively speaking, the Liquid sidechain works on top of Bitcoin or rather alongside it. One could also say that Liquid is its own blockchain that is adjacent to Bitcoin. After all, Liquid has its own consensus mechanism and rules that are different from Bitcoin’s. Just like Bitcoin’s consensus rules though, Liquid’s rules are written in code and enforced by nodes.
As a sidechain of Bitcoin, Liquid’s purpose is to enhance Bitcoin’s capabilities in various ways. For one, Liquid allows for a much faster final settlement. Whereas Bitcoin blocks are on average added every 10 minutes, Liquid blocks are processed and added to the Liquid sidechain precisely every minute. In addition, reorganizations are disallowed, ensuring that two confirmations are sufficient to establish the final settlement of a transaction.
Another enhancement is Liquid’s possibility to allow for the tokenization of multiple assets. Through the Liquid sidechain, third parties are able to issue all sorts of tokens, from securities and digital collectibles to stablecoins and more.
A third improvement that Liquid brings to the Bitcoin ecosystem is confidential transactions. Contrary to Bitcoin, where all transactions are openly visible in a pseudonymous fashion, the Liquid Network makes it possible to mask the amount and asset type of a transaction. This way, users of the Liquid sidechain can transact privately. What’s important to note though: Transactions are not completely anonymous as they are visible to Liquid’s sidechain maintainer, also called Liquid functionaries (more on them shortly). Still, Liquid gives its users more privacy than they have on the Bitcoin mainchain.
Ultimately, Liquid is one of several attempts to properly scale Bitcoin through additional technology platforms that are built alongside Bitcoin. As such, Liquid is one puzzle piece in the decentralized endeavor to build a multi-layered Bitcoin-based financial order. Of course, the Liquid sidechain itself cannot simply make away with the inherent Blockchain trilemma every public blockchain is faced with today. In the case of Liquid, the priorities have been shifted away from absolute decentralization and censorship resistance associated with Bitcoin to better scaling and more functionality with Liquid.
Consensus by Strong Federations
Let’s take a closer look at Liquid’s consensus mechanism. In a sense, the Liquid sidechain is most similar to a federated blockchain. Its approach to consensus is called Strong Federations. This consensus mechanism removes the need to perform the costly proof-of-work that Bitcoin miners need to do in order to secure the Bitcoin blockchain. Instead, with Strong Federations, the consensus is replaced with the collective actions of a group of mutually distrusting actors called Liquid functionaries.
As federation members, these functionaries are the ultimate maintainer and securer of the Liquid sidechain. They serve two basic roles on the Liquid network: Firstly, functionaries act as block signers, so transactions on the Liquid network can be processed. Liquid’s federated model requires blocks to be signed by at least two-thirds of all block signers. Block signers take turns proposing a new block every minute in a round-robin fashion, and other functionaries sign that block after validating its contents.
Secondly, they act as watchmen that validate all the transactions according to Liquid’s consensus rules. This way, they secure the network. Also, part of this second function is securing bitcoin units that are held by the network. When a user wants to use Liquid, Liquid Bitcoin (L-BTC) need to be issued. To issue them, bitcoin units must be “transferred” from Bitcoin’s mainchain to the sidechain. These bitcoin units are then “frozen” on Bitcoin’s base layer (read Bitcoin blockchain) for the exact time that they remain on the sidechain. If the user moves the bitcoin back to the base layer, the corresponding L-BTC units are deleted, and the mainchain releases the locked bitcoin. This process is referred to as pegging-in and pegging-out.
At launch, the Liquid Network was started with a fixed group of functionary members. Currently, there are 15 of them. With an update called Dynamic Federations, the number of functionaries will expand even more. As all code updates are open, auditable, and require approval by functionaries, such changes cannot just be implemented without the consent of a majority of functionaries.
All of the functionaries are independent companies running dedicated cryptographic tools and highly secure functionary hardware called Liquid functionary. This is a specialized server device that includes a Hardware Security Module (HSM) for securing the functionary’s private keys. By using these modules, it can be ensured that a functionary’s task is performed autonomously and without human intervention.
The assurances with Liquid are as follows: The functionaries cannot change the Liquid blockchain, but they have the option not to execute required bitcoin transfers from the sidechain to the mainchain. At worst, they could even steal them if they manage to conspire against Liquid users. Ultimately, Strong Federations introduce a simple trust model: as long as a quorum of functionaries acts honestly, the system continues to function as intended. But even if Liquid’s consensus would experience a failure (that is not related to conspired theft by functionaries), it has a mechanism that allows settlement of L-BTC back to the Bitcoin blockchain.
Participant members and full nodes
Besides the functionaries, there are other participants in the Liquid network. So-called participants members without functionary hardware connect to the Liquid Network by using pseudo-functionary nodes that connect to all functionaries. While not securing the network (only done by functionaries), these participant members can perform peg-ins, peg-outs, send Liquid transactions, and fully validate the Liquid sidechain.
A third set of actors are those that “only” run a Liquid full node. Running a full node within the Liquid Network is open to anyone. The connection is established through so-called bridge nodes that are run by functionaries and participant members. With a Liquid full node, anybody can trustlessly self-validate the Liquid sidechain. Also, users running a full node can independently perform a peg-in to the network, perform confidential transactions, and issue tokenized assets on Liquid. Contrary to participant members, users running a full node cannot do peg-outs. In order to “transfer” L-BTC from the sidechain back to the mainchain, Liquid users running a full node must go through so-called Liquid functionaries or participant members.