What is the Liquid Network?

1. What is the Liquid Network?

Liquid Network is a federated bitcoin sidechain that functions as a settlement and payment network for cryptocurrency exchanges, market makers, brokers and other market participants.

Liquid sidechain is based on Elements source code and uses Strong Federation technology.

2. How did Liquid Network originate?

In the fall of 2014, Blockstream published a white paper on sidechain technology called Sidechain Elements.

In June 2015, Blockstream announced the release of an open source code and test network for Sidechain Elements. The presented code was intended to allow developers to experiment with Sidechain functionality, at an entry level allowing for the creation and transfer of digital value.

In late 2015, Blockstream announced its first commercial application, Liquid, based on sidechain technology. Liquid launched in test mode.

In December 2016, the U.S. Patent and Trademark Office (USTPO) published Blockstream’s patent application related to sidechains.

In January 2017, Blockstream unveiled a new white paper on the project, containing an updated consensus mechanism and trust model, as well as a description of mechanisms to ensure that sent funds are returned to the parent chain in the event of failure.

In May 2017, Blockstream’s first commercial application based on sidechain technology was launched in beta mode.

In July 2018, Blockstream introduced Issued Assets (IA), a tool that allows users to create their own tokenized assets in the Liquid sidechain.

In October 2018, Liquid was officially released.

In November 2018, Blockstream publicly launched blockstream.info, a blockstream reviewer for Liquid’s sidechain and bitcoin network. The tool allows you to track bitcoin addresses to which transactions in the sidechain are linked. Blockstream also introduced a client to run a full node on the Liquid network.

3. Why do we need the Liquid Network?

Existing blockchains have not yet solved the scaling problem.

In theory, the easiest way to solve it is to increase the block size, so that additional transactions can be included in the block and fees can be reduced. This approach requires additional hardware resources to manage full network nodes, so it eliminates limited nodes at the expense of decentralization. Bitcoin Cash followed this path.

Another solution to the problem is sharding. It involves partially eliminating the parallel functioning of transactions/blocks. The network is divided into sections that can operate independently. Section A interacts with one series of transactions, section B with another.

This mechanism leads to a doubling (in the case of two sections) of transaction volume, as the ability of nodes to process them simultaneously is limited. By dividing the blockchain into sections, the number of transactions supported can be incrementally increased. Each section or part of the blockchain (shard) is capable of processing transactions independently. Implementing this model presents significant challenges, and dividing a classic blockchain into hundreds of parts jeopardizes consensus mechanisms.

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Another possible solution is the Lightning Network, a micropayment technology that operates offchain and partially independently of the bitcoin blockchain. It offers virtually “unlimited” scalability, since miners no longer need to validate all transactions. However, the features and integrity of the bitcoin blockchain are partially lost in such a model, although for small transactions this is a more acceptable compromise.

Another approach to solving the problem is to create a sidechain tied to the bitcoin blockchain. Creating a sidechain requires a second-tier solution, since it is a partial offchain relative to the main bitcoin blockchain.

4. How does the Liquid Network function?

The Liquid Network’s sidechain is a separate private blockchain with a two-way link to the parent blockchain.

So-called dummy tokens (L-BTC) are used for money transfers. They are pegged to bitcoin at a 1:1 ratio.

The user of the parent blockchain must first send the coins to an outbound address, where they are “locked” by members of a so-called federation, which is designed to prevent them from being spent elsewhere.

A federation is a group of operators that acts as an intermediate point between the main chain and one of its sidechains. It guarantees the interoperability of the system, as well as the ability to switch from the main blockchain to a sidechain at any time.

The federation also ensures that each convertible bitcoin in the sidechain corresponds to an equivalent bitcoin frozen in a swap wallet that acts as a bridge. They can only be unblocked if a sufficient number of key holders authenticate the payment.

For added security, this occurs after a certain waiting period. After that, an equivalent number of coins are transferred to the sidechain, and the user has the opportunity to spend them. When coins are sent from the sidechain to the main blockchain, the reverse process occurs.

Transactions performed on the secondary blockchain are not recorded in the primary blockchain, so commissions can be much lower or zero.

5. What are Confidential Transactions?

Confidential Transactions technology allows you to make the amount sent visible only to the parties directly involved in the transaction or to a third party designated by them.

CT makes it possible to send private “memo” data (e.g., refinancing addresses) without increasing the size of the transaction at the expense of over-declaring most of the top cryptographic protection.

CTs are based on the Pedersen Commitment Scheme concept of allowing the user to keep some data private, but make it mandatory (immutable) in the future.

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6. What are Issued Assets?

Issued Assets is a tool that allows users to create their own tokenized assets in the Liquid sidechain.

These assets can represent existing financial instruments (tokenized fiat, crypto-assets, certified assets such as gold coins) as well as brand new assets.

The main features of Issued Assets:

  • Issuing a new asset in any quantity;
  • Sending multiple assets in a single transaction;
  • Ensuring privacy with Confidential Transactions;
  • Asset Destruction;
  • Ability to create additional asset quantities in the future.

These properties can be used to create digital collectibles and reward points in the Liquid sidechain, as well as to conduct token sales.

They allow atomic swaps to be used to trade one asset against another without the involvement of a trusted third party. Since Issued Assets and bitcoin can be both the input and output of a Liquid transaction, bitcoin can be exchanged for or back from an asset in a single transaction.

7. How does bitcoin (BTC) become L-BTC and vice versa?

A Liquid user can send bitcoins to an address controlled by the Liquid Federation: as soon as the main circuit transaction receives 102 confirmations, the user is given credit in L-BTC.

The high confirmation threshold is necessary as a guarantee that the network will remain solvent in case the parent blockchain is reorganized.

Liquid federation members retain a portion of their funds in L-BTC in an amount dependent on user demand, and can change the balance as needed. If a user wishes to transfer L-BTC back to BTC, they can perform a transaction in which bitcoins are “detached” from L-BTC and members are notified to make a payment to the main chain. Such an option is only available to Liquid members.

8. What entities are members of the Liquid Federation?

The Liquid Network Federation consists of a group of exchanges, trading platforms and other financial institutions. Read an updated list of official members here.

Blockstream does not control the network and only acts as a technology provider to network members. Liquid can continue to operate even if Blockstream ceases to exist or network members withdraw support from the company.

9. What opportunities does Liquid offer end users and traders?

With Liquid, users and federation members have the ability to transfer bitcoins between participating exchanges, which can send L-BTC on their behalf. End users can also withdraw L-BTC from exchanges to Liquid-supported wallets (such as Green), or withdraw from a particular exchange directly to their deposit addresses on another exchange that is a member of Liquid.

10. How do traders move funds using Liquid?

Exchanges can maintain an L-BTC balance by quickly converting funds from users’ deposits into bitcoins. Exchanges with L-BTC deposits can receive deposits and credit their customers’ accounts in minutes.

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11. How do traders reduce custodial risk with Liquid?

Often, traders need to place funds on the exchange for an extended period of time so that they don’t miss out on favorable trading opportunities. Liquid allows traders to move L-BTC into their own wallets, while still being able to withdraw those funds back to the exchange within minutes.

Traders are able to use a multi-signature trust model to hold their assets rather than relying on a single exchange.

12. Who can manage a full Liquid node?

Anyone. Download the node software here.

13. What happens to the bitcoin held by the federation if Liquid stops functioning?

There are emergency keys through which bitcoin held by Liquid can be accessed. Such keys are intended solely for situations where the network is down for an extended period of time, and allow bitcoins stored by the Liquid network to be returned to the last owner on the Liquid blockchain.

Issued Assets can be moved to other platforms or new blockchains compatible with Liquid, depending on the preferences of the issuer of the asset.

14. How is the Liquid Network evolving?

In March 2020, Long Hash researchers discovered that more bitcoins were circulating in Liquid than in the Lightning Network.

That same month, the Blockstream team announced a reduction in transaction fees to 0.1 satoshi per byte and an expanded proof range for confidential transactions.

15. What are the benefits of the Liquid Network?

The main advantage of sidechain is a higher number of transactions per second and a shorter transaction confirmation time.

Liquid Network offers:

  • Virtually instant transfers between exchanges, market makers, and some wallets.
  • Increased efficiency for traders as sidechains allow you to move significant capital from one market to another.
  • Verifiable auditing: Liquid Network users verify confirmations of reserves of various assets secured by exchanges;
  • Confidential transactions, implying a greater degree of privacy than bitcoin. Liquid Network’s sydchain is invulnerable to transaction analysis tools.

16. What are the drawbacks of the Liquid Network sidechain?

  • The potential transition of most bitcoin users to the sidechain poses a certain threat to miners, who make money from network commissions, among other things.
  • A significant drawback of the Liquid Network is the fact that it is a private network run by trusted entities. Such a model contradicts the philosophy of decentralization.
  • Sidechains will never have the level of security comparable to bitcoin.

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