What Are Off-Chain Transactions (Cryptocurrency)?

Off-chain transactions refer to those transactions occurring on a cryptocurrency network which move the value outside of the blockchain. Due to their zero/low cost, off-chain transactions are gaining popularity, especially among large participants.

Off-chain transactions can be contrasted with on-chain transactions.

Key Takeaways

  • In blockchain-based cryptocurrencies, off-chain transactions refer to those which occur outside of the blockchain itself, and can be contrasted with on-chain transactions.
  • Off-chain transactions can work by swapping private keys to an existing wallet instead of transferring funds, or by using a third-party or coupon-based interlocutor.
  • Off-chain transactions can entail lower fees, immediate settlement, and greater anonymity than on-chain transactions.
  • Depending on the method used, off-chain transactions may eventually have to be recorded on-chain.

How Off-Chain Transactions Work

Off-chain transactions can be better understood when compared to on-chain transactions.

An on-chain transaction, simply called a transaction, occurs and is considered valid when the blockchain is modified to reflect the transaction on the public ledger. It involves the transaction being validated and authenticated by a suitable number of participants, recording of the details of the transaction on the suitable block, and broadcasting of the necessary information to the whole blockchain network, which makes it irreversible. This kind transaction can be reversed only after a majority of the network's hashing power comes to an agreement.

Essentially, every step linked to an on-chain transaction occurs on the blockchain, and the blockchain status is modified to reflect the occurrence and validity of the transaction. (For more, see What does a block chain record in a bitcoin exchange transaction.)

In contrast, an off-chain transaction takes the value outside of the block chain. It can be executed using multiple methods.

  1. First, there can be a transfer agreement between transacting parties.
  2. Second, off-chain transactions can involve a third-party such as a guarantor who guarantees honoring the transaction. Present day payment processors like PayPal work on these lines.
  3. Another method for off-chain transaction is to use a coupon-based payment mechanism. A participant purchases coupons in exchange for the cryptotokens, and gives the code to another party which can then redeem them. Redemption is possible in the same cryptocurrency or in different ones, depending on the coupon service provider.

In the simplest way, two parties can even exchange their private keys involving a fixed amount of cryptocoins. This way, the coins never leave the address/wallet, but the currency receives a new owner off-chain.

Advantages of Off-Chain Transactions

First, they can be executed instantly. On-chain transactions can have a lengthy lag time depending upon the network load and number of transactions waiting in the queue to be confirmed.

Second, off-chain transactions are usually don't have a transaction fee, as nothing occurs on the blockchain. Since no miner or participant is required to validate the transaction, there is no fee, making it an attractive option for especially if large amounts are involved. On the other hand, on-chain transactions may at times come at a high cost, which leads to problems of Bitcoin Dust, a situation where small amounts of bitcoins cannot be transacted due to high transaction fees.

Third, off-chain transactions offer more security and anonymity to the participants, because details are not publicly broadcast. In case of on-chain transactions, it is possible to partially derive a participant’s identity by studying transaction patterns.