Research

Crypto Simplified: Explaining Sidechains

Image Credit: Bitcoin Wiki

Quick Take

  • Sidechains are a clever workaround to implementing new features without launching an entirely new token
  • Projects are trying to make Bitcoin work faster while extending its capabilities
  • One major challenge is creating incentives for miners to participate in sidechains

The launch of Blockstream’s Liquid Network brings with it a resurgence of questions surrounding sidechains. As with everything we do here at The Block we are going to take a “Crypto Simplified” approach at explaining sidechains.

What are sidechains?

In simplest terms, sidechains are a separate blockchain attached to the main blockchain, or main chain, through the use of a two-way peg. Through this two-way peg system, sidechains can issue an asset that is backed at a fixed exchange rate to a main-chain asset. In the case of the Liquid Network, Liquid Bitcoin (LBTC) is pegged at a 1-to-1 ratio to bitcoin (BTC). Users of sidechains will typically be required to prove that they own the assets they are trying to peg. They do this by sending their assets to a custom blockchain address for miner confirmation. Once an asset’s ownership verified, a sidechain can issue its pegged asset to the user. The original main chain asset will be locked in the address until the user redeems their sidechain asset.

Crypto Simplified diagram of a sidechain asset issuance process


What are the benefits of sidechains?

By creating a pegged asset, sidechains remove the limitations of the main chain. Because of this, developers of sidechains are free to experiment with new features without compromising the main chain. These features can come in the form of instant transactions, enhanced liquidity, increased privacy, etc.

Currently, some notable sidechains of Bitcoin include:

  • RSK which introduces smart contract features to Bitcoin, bringing some of the benefits of Ethereum to the original crypto
  • Liquid which introduces faster trading, increasing capital efficiency, and better privacy to Bitcoin
  • Hivemind which introduces prediction market capabilities to Bitcoin

What are the risks of sidechains?

Because sidechains are effectively independent blockchain networks, they need their own miners to verify and confirm transactions. However, because sidechains are pegged to a main chain asset, there is little to incentivize for miners to mine sidechains.

The lack of incentives is a major downside. Because miners have no incentive to secure a sidechain, sidechains are vulnerable to miner attacks. These attacks can come in the form of fraudulent transactions, miner centralization, and 51% attacks.

How do you incentivize miners?

While miner incentives are far from perfect, developers have experimented with a variety of incentive mechanisms for sidechain security:

  • Demurrage: Demurrage is a tax on held assets. On sidechains, a demurring asset will give up a percentage of its value over time — redistributing this lost value to miners.
  • Merge mining and fees: Merged mining allows a miner to mine on more than one blockchain simultaneously. In the case of sidechains, miners that implement merge mining are rewarded with mining fees with limited additional work/energy use.
  • Native tokens: Sidechains could issue its native token to rewards miners for securing the network. This would effectively make sidechains an altcoin, instead of a pegged asset.
  • Business Alignment: Sidechains could also be run by a consortium of businesses that have no incentive to disrupt the sidechain. Liquid runs very similarly to this method, as it is a federated sidechain. Exchanges using the Liquid sidechain are incentivized by the increased operational efficiency of using Liquid and not by the mining fees.

Currently, when users want to access features on a different blockchain, they are forced to buy the native token of that blockchain. If sidechains work as intended, they could remove the need for altcoins, opening up the door for an entire ecosystem built on a single base blockchain.