Liquid Sidechains and the Price of Bitcoin

4 minute read

Posted by: pesa_mic

October 20, 2015

Blockstream, a bitcoin startup with a team comprising of renowned architects of Bitcoin, cryptographers, and cypherpunk heavyweights, announced a product code named Liquid, set for release in Q1 2016. Liquid, a commercial sidechain, builds upon proposals set out in the original sidechains white paper.

“Liquid offers instant transactions, providing a fast settlement layer for bitcoin exchanges, brokerages and other industry members.” – Bitcoin Magazine

Ever since the whitepaper, Sidechains has been a much anticipated project. Mainly because it adds value to the main Bitcoin blockchain by increasing its utility for payments (amongst others), currently limited by the slow confirmation time of the Bitcoin blockchain. More importantly, the team at Blockstream is 100% committed to maintaining the fungibility of bitcoins and its censorship resistance quality. Blockstream’s team of veterans, have seen it all.

Liquid, is their first attempt at a real offering that enhances the value of the bitcoin blockchain. For instance, it cuts down the time taken to move funds between exchanges to seconds from 60 minutes. Currently, companies in the bitcoin ecosystem have to rely on slow confirmation times when making settlements between themselves – Interchange Settlement Lag (ISL)

“key players in the Bitcoin market, including exchanges, payment processors, traders, and remitters, experience delays when moving bitcoin between accounts in different locations.”

Confirmations on the main blockchain severely limits liquidity, settlement speeds and trading activity between exchanges. By using a sidechain pegged to the main blockchain, blockstream seeks to remedy this.

Even more exciting, is its broad use case, not just limited to exchanges. Such a system could easily incorporate payment processors, merchants, exchangers.

“offering will serve bitcoin exchanges, payment processors and traders by reducing the time in which bitcoin-denominated funds can be transferred between accounts at these institutions.”

The technical details of how it works has raised the question of whether this is yet another permissioned private blockchain that seem to be popular in mainstream Fintech.

How does Liquid work?

Liquid works by having participating members join a federation of validators. Each of these members has a stake in this federation, contributing a certain amount of bitcoins held as collateral. Because bitcoin is a bearer instrument, it is appropriate as a collateral and settlement since ownership can be proved cryptographically. The security of this collateral is kept in check by federated members.

At the time of the announcement, members included Xapo, BTCC, Kraken and Unocoin.

Partner exchanges transfer bitcoin funds to a shared multi signature wallet address. A Byzantine round robin consensus protocol,is applied for processing transactions, together with agreed upon rules on confidential transactions. In essence, these federated partners run a blockchain parallel to the main blockchain. Hence, a chain of transactions blocks pegged to Bitcoin. Moving bitcoins into and out of this sidechain requires Proof of Work on the main chain, while the federated consensus mechanism operates the 2way peg as multi-signers, with each member running their own node. Unlike on the main blockchain, on liquid sidechain, all participants are known to each other. This distribution, ensures no central authority, not even Blockstream, can impose undue authority;

It has been referred to as an auditable chain of transaction blocks using a federated model for transaction validation ie a blockchain

“a private permissioned ledger that you fund by sending coins to a multisig addresses that are held in custody by the federated members.”

What does this mean for the price of bitcoin?

Liquid has tremendous implications on the value of bitcoin. Effectively, it creates an efficient global remittance network, even better, a high speed global banking system with bitcoin as its reserve currency. In the past, under the gold standard, Banks used to shuffle gold between themselves to balance settlements but now, with Liquid, we just shuffle bitcoin.

This functionality entrenches use of bitcoin as a reserve currency, which subsequently impacts the value of bitcoin as a bearer instrument.

Connecting exchanges order books will improve capital adequacy and market liquidity. Because accounts held at different brokerages and exchanges can cross settle securely within seconds, access to competitors’ order books opens up a global order book. Institutional capital, traders, family offices and traders can trade bitcoin on deeper markets, as exchanges move closer to resembling traditional derivatives and stock markets. Bitcoins exchanges could soon become mere ATMs.

This is certainly the type of infrastructure that is much needed for bitcoin as an alternative asset class to affirm itself mainstream. I am excited to see how this develops over the next year. More capital coming into bitcoin, speculators, trading platforms, rapid settlements, brokerages – all ultimately add value to the price of bitcoin. It is only a matter of time before bitcoin, will be as valid as any other asset class, in the eyes of the mainstream average investor. This means a higher bitcoin price than we have today.

Updated: 2015-10-20