Liquid Network on Bitcoin
Expanding the possibilities of Bitcoin Layer 2
Why Bitcoin?
At its core, Bitcoin offers several key features that differentiate it from traditional financial systems. These features include:
Absolute Scarcity. With a maximum supply of 21 million coins, Bitcoin embodies scarcity, much like gold - only better. This scarcity ensures that Bitcoin cannot be devalued or diluted, providing a hedge against fiat currency debasement.
Peer-to-Peer Transfers. Bitcoin enables seamless and secure peer-to-peer transactions worldwide. Whether you're sending value to your neighbor or someone on the other side of the globe, all you need is a computer and an internet connection.
Independence from Legacy Systems. Unlike traditional financial infrastructure, the Bitcoin network operates independently. It serves as the first global digital payments infrastructure, free from the control of any person or group.
Trustlessness and Security. Bitcoin's decentralized and immutable ledger, coupled with its "proof of work" consensus mechanism, ensures that the system remains trustworthy and immune to manipulation. This integrity is lacking in our current financial system.
Simplicity and Accessibility. Bitcoin's digital nature simplifies the validation, storage, transfer, and security of assets. Unlike gold, it doesn't face the same challenges when handling large amounts, making it more accessible to everyone.
Expanding adoption of Bitcoin is very important for the healthy growth of the network. I recently wrote a summary of Fedimint, a modular open source protocol to custody and transact bitcoin in a community context, built on a strong foundation of privacy. You can check it out here:
This week, I thought I would dive into the Liquid Network, which has similar features to Fedimint, but also some notable differences. Later on in the post, I’ll compare and contrast the two protocols.
Introduction
The Liquid Network is a sidechain built on top of the Bitcoin blockchain that aims to provide faster and more confidential transactions. It was developed by Blockstream, a blockchain technology company.
Sidechains are separate blockchains that are interoperable with the main Bitcoin blockchain, allowing for the transfer of assets between the two chains. The Liquid Network operates as a federated sidechain, meaning that a group of trusted functionaries, known as functionary nodes, validate transactions on the sidechain.
The Liquid Network offers several key features:
Faster transactions: Liquid enables faster settlement times compared to the Bitcoin blockchain. Blocks are generated on the Liquid Network every minute, allowing for quicker confirmation of transactions.
Confidential transactions: Liquid supports confidential transactions, which means that transaction amounts and asset types can be hidden from the public. This feature enhances privacy and confidentiality for participants using the Liquid Network.
Issued assets: The Liquid Network allows users to create and trade assets, known as L-BTC (Liquid Bitcoin), and other tokens on the sidechain. These assets are pegged to their corresponding value on the Bitcoin blockchain, allowing for seamless transfer and trading.
Interchangeability: Assets issued on the Liquid Network can be transferred back to the Bitcoin blockchain at any time. This interchangeability ensures that the value stored in Liquid can be moved back to the main Bitcoin network if desired.
The Liquid Network is primarily designed for use by cryptocurrency exchanges, financial institutions, and other entities that require fast, confidential, and secure transactions. It enables these entities to move funds more efficiently and privately without relying solely on the slower settlement times of the Bitcoin blockchain.
Technical Summary
Network Structure: Liquid is operated by members such as exchanges, financial institutions, and Bitcoin-focused companies globally. Blockstream acts as a technology provider, and no single entity has control over the network. The network uses a consensus approach called Strong Federations, where a group of mutually distrusting participants, called functionaries, collectively secure the network.
Functionaries: Functionaries have two roles: block signers and watchmen. Block signers generate blocks every minute, ensuring consistency and finality of transactions. Watchmen secure the Bitcoin held by the network. Blocks are signed by at least two-thirds of all functionaries, and block creation resumes when a quorum is reached.
Peg-in and Peg-out: Peg-in involves moving funds from Bitcoin to Liquid, while peg-out is the process of moving funds from Liquid back to Bitcoin. Peg-in transactions require 102 confirmations on the Bitcoin network for security. Peg-out processing time varies based on network conditions and watchman status, typically taking 11 to 35 minutes. Watchmen ensure peg-outs are authorized and update the Peg-out Authorization Key (PAK) list every three days.
Emergency Recovery Procedure: Multisig and timelock mechanisms are implemented to safeguard funds in case of network disruption. If one-third or more of the network fails, emergency keys can be used to access funds after an extended non-functional period.
Hardware and Participants: Functionary servers consist of host servers and key storage modules, ensuring security and preventing remote attacks. Participants connect to the network using pseudo-functionary nodes. The general public can participate by running a full node, allowing self-validation of the Liquid chain.
Confidential Transactions and Asset Issuance: Liquid's default use of Confidential Transactions ensures the privacy of asset and amount information. Issued Assets functionality enables the creation and transfer of various assets, including tokenized fiat, digital collectibles, and attested assets.
For more information, see the Liquid Whitepaper here.
Use Cases
Cryptocurrency Exchanges: The Liquid Network provides faster and more confidential transactions, making it beneficial for cryptocurrency exchanges. Exchanges can use Liquid to facilitate quicker Bitcoin transfers between themselves, improving liquidity and enabling faster trading opportunities.
Arbitrage and Market Making: Traders and market makers can take advantage of the Liquid Network's faster settlement times to engage in arbitrage strategies between different exchanges. They can exploit price discrepancies and execute trades more quickly, capitalizing on market inefficiencies.
Tokenized Assets: The Liquid Network enables the issuance and transfer of various digital assets through its Issued Assets feature. Businesses can tokenize fiat currencies, securities, digital collectibles, loyalty points, and other assets on the Liquid sidechain. This opens up opportunities for creating new financial instruments and facilitating asset transfers with enhanced efficiency and privacy.
Interoperability and Atomic Swaps: Liquid's interoperability allows for atomic swaps between different cryptocurrencies and assets issued on the network. This means businesses can swap Bitcoin with other supported assets without the need for intermediaries, reducing counterparty risk and streamlining cross-chain transactions.
Confidential Transactions: Liquid's default use of Confidential Transactions ensures that the amounts and types of assets being transacted remain hidden. This feature can be valuable for businesses that prioritize privacy and want to protect sensitive financial data during transactions.
Cross-Border Payments: The Liquid Network's fast settlement times and tokenized assets make it suitable for cross-border payments. Businesses can leverage Liquid to transfer funds quickly and securely across borders, avoiding the delays and fees associated with traditional banking systems.
Financial Institutions: Banks and other financial institutions can benefit from the Liquid Network by leveraging its features for more efficient and secure asset transfers. They can utilize Liquid for interbank settlements, issuance of digital assets, and other financial services.
These use cases are not exhaustive, and the potential applications of the Liquid Network can expand as the technology evolves and businesses explore new possibilities.
Risks and Trade-Offs
While the Liquid Network offers various advantages, there are also certain risks and trade-offs associated with its use. Here are some important considerations:
Centralization: The Liquid Network relies on a federation of trusted functionaries to validate transactions. While this allows for faster and more confidential transactions, it introduces a certain level of centralization. The functionaries are chosen by Blockstream, and they have the power to enforce consensus rules on the Liquid Network. This centralized control differs from the decentralized nature of the Bitcoin blockchain, where miners validate transactions.
Counterparty risk: The assets on the Liquid Network, such as L-BTC or other issued tokens, are custodial in nature. This means that users must trust the functionaries to properly manage and secure the assets held on the network. If the functionaries were to act maliciously or if the network's security were compromised, there could be a risk of losing funds or experiencing other security vulnerabilities.
Limited adoption and liquidity: The Liquid Network is not as widely adopted as the Bitcoin blockchain. Therefore, liquidity and trading options may be more limited compared to Bitcoin itself. Users might find fewer exchanges or services that support the Liquid Network, reducing their ability to easily transact or exchange assets on the sidechain.
Dependency on the Bitcoin blockchain: While the Liquid Network offers faster settlement times, it is still dependent on the security and stability of the Bitcoin blockchain. If there were any issues or vulnerabilities discovered on the Bitcoin blockchain, it could potentially impact the security and trustworthiness of the Liquid Network.
Regulatory concerns: As the Liquid Network enables confidential transactions and the issuance of tokens, it may raise regulatory concerns in some jurisdictions. The ability to hide transaction amounts and asset types could potentially attract scrutiny from regulatory authorities who may seek greater transparency in financial transactions.
Other Concerns
There have been various critics of the Liquid Network, expressing concerns about its design and implementation. One of the notable critics is Peter Todd, a well-known Bitcoin developer and researcher. His main concern revolves around the federation model and the reliance on a group of trusted functionaries to secure the network. Todd argues that this approach compromises the decentralization and censorship resistance that are core principles of Bitcoin. He raises concerns about the potential for collusion or coercion among the functionaries, which could undermine the trust and security of the Liquid Network.
Another critic is Samson Mow, the former Chief Strategy Officer of Blockstream (the company behind Liquid). While he has been involved in the development of Liquid, Mow has expressed concerns about the potential centralization of power within the federation. He has emphasized the need to continually evaluate and improve the network's design to ensure it remains secure and decentralized.
Criticism of the Liquid Network primarily focuses on its reliance on trusted functionaries and the potential concentration of power rather than technical flaws or vulnerabilities. Critics argue that these concerns go against the principles of decentralization and censorship resistance that are central to the ethos of Bitcoin. I would agree with that and add that I’m not a big fan of stablecoins, NFT’s or shitcoins which are all enabled on Liquid since crypto trading is a supported use case.
On the other hand, having off-chain scalability solutions like Liquid can help advance Bitcoin adoption (with certain trade-offs) and can support many business use cases as outlined previously.
Liquid vs Fedimint
The following discussion briefly compares and contrasts Fedimint and Liquid:
Custody Model: Both Fedimint and the Liquid Network offer alternative custody models for Bitcoin. However, their approaches differ. Fedimint focuses on community custody, where users rely on trusted federations to manage their funds collectively. On the other hand, the Liquid Network is a sidechain solution that relies on a federation of trusted functionaries to secure and manage the assets.
Privacy: Fedimint emphasizes financial privacy by incorporating cryptographic techniques like Chaumian eCash notes and blinded signatures. This enables federation members to transact without revealing specific transaction details or balances to anyone, including the Fedimint operators. In comparison, the Liquid Network primarily focuses on asset issuance and transfer capabilities, offering privacy features through the use of confidential transactions (similar to Fedimint, these are also not visible to the operators of the Liquid Network).
Scaling: Both Fedimint and the Liquid Network aim to address scalability challenges. Fedimint proposes scalability through the federated custody of funds while maintaining interoperability with the Lightning Network. By aggregating and sharing ownership of UTXOs, Fedimint aims to create a more flexible and efficient Lightning Network. The Liquid Network, on the other hand, provides a separate blockchain that enables faster and more confidential transactions, allowing for increased transaction throughput.
Trust Model: Fedimint relies on a trust model that involves trusting the federation guardians for custody, Lightning Gateway providers for payment facilitation, and a quorum of federation guardians for transaction execution. The Liquid Network, on the other hand, requires trust in the functionaries that make up the federation responsible for block production and asset issuance.
Use Cases: Fedimint primarily targets pre-existing groups with high levels of trust, such as families, friends, and community organizations. It aims to simplify the user experience, promote privacy, and enable community-focused banking with a focus on increasing broader Bitcoin adoption. The Liquid Network, on the other hand, caters to a broader range of use cases, including token issuance, trading, and exchange functionality, particularly for businesses and institutions.
Not financial or legal advice, for entertainment only, do your own homework. I hope you find this post useful as you chart your personal financial course and Build a Bitcoin Fortress in 2023. To see all my books on investing and leadership, click here. Â
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