A Beginner’s Guide to the Liquid Network
June 15, 2023
It’s becoming increasingly clear that the Bitcoin network will scale in layers. One of the most exciting layer-2 scaling solutions is the Liquid Network.
Read on to learn what the Liquid Network is and how it works in this comprehensive beginner’s guide.
What is the Liquid Network?
The Liquid Network is a sidechain-based layer-2 Bitcoin solution that scales the Bitcoin network by enabling faster transactions. Moreover, it facilitates confidential transactions as well as the issuance of stablecoins, security tokens, and other digital assets on the Liquid sidechain.
A sidechain is an independent network that runs parallel to the base layer but uses its own consensus mechanism. As a sidechain, the Liquid Network runs on top of Bitcoin but isn’t fully permissionless.
The Liquid Network doesn’t use the same consensus model as Bitcoin. Instead, it utilizes a federated peg mechanism to interact with Bitcoin. This enables seamless transfer of Bitcoin between the two networks. When moving funds from Bitcoin to Liquid, BTC is locked on the base layer, and an equivalent amount of Liquid’s asset, L-BTC, is unlocked on the sidechain. Conversely, L-BTC is burned, and Bitcoin is unlocked when moving funds back from Liquid to Bitcoin. Importantly, L-BTC's supply is always maintained at a 1:1 ratio, with BTC held in a multisig wallet.
Launched in October 2018, Liquid was developed by Blockstream. It's an implementation of an open-source blockchain platform called Elements. Elements is built on the Bitcoin codebase and, thus, enables sidechains. Liquid is governed by a federation consisting of leading crypto exchanges, financial institutions, wallet providers, payment platforms, and digital asset managers.
How Does the Liquid Network Work?
Consensus Model
A group of 15 Federation members called functionaries is responsible for securing the Bitcoin that backs L-BTC and operating the sidechain. The role of operating the sidechain is referred to as block signing. Functionaries take turns proposing a new block every minute while the other block signers validate the transactions in the block and sign it.
Liquid’s federated consensus model requires no less than two-thirds of the functionaries to verify and sign blocks. That means the sidechain can still operate as normal when less than one-third of the functionaries are offline. However, it will stop operating if one-third or more of the functionaries are offline.
Functionaries also play the role of watchmen, where they manage and secure the BTC held in on-chain custody to back L-BTC. This BTC is, of course, stored on the Bitcoin blockchain and is only accessible via a multisig wallet. The wallet is signed by two-thirds plus one of the total functionaries.
Peg-In and Peg-Out
When moving BTC from Bitcoin to Liquid, a user sends BTC to the address generated by the Liquid client software. The software then creates a peg-in transaction to create an equal amount of L-BTC (Liquid Bitcoin) on the sidechain. After 102 confirmations on the Bitcoin network, functionaries accept the locking of BTC and allow the user to receive their L-BTC on the Liquid Network.
If a user wants to move BTC back to the Bitcoin network, they create a peg-out transaction. Next, they send L-BTC to a burn address, where it's permanently removed from the Liquid Network. Peg-out transactions require two confirmations on the Liquid Network, after which BTC is sent from the multisig wallet to the whitelisted address of the federation member executing the peg-out. A Federation member’s wallet processes peg-out transactions in batches. Each round takes between 20 and 60 minutes. After processing, the user receives BTC in their wallet.
Besides going through a federated member to peg out BTC, users can convert L-BTC to BTC on several exchange platforms.
Full nodes
Anyone can run a Liquid full node to verify that L-BTC is backed by Bitcoin at a ratio of 1:1. They can also self-verify other network activities like transactions, new blocks, and peg activity. Furthermore, full nodes can conduct confidential transactions and interact with the issued assets feature on Liquid. Nevertheless, full nodes do not secure the network or carry out peg-out transactions.
Full nodes connect to the Liquid Network through bridge nodes operated by federation members. Bridge nodes act as extra layers of security, protecting the network from Denial of Service (DoS) attacks.
Liquid Wallet Users
Users that do not want to run a Liquid node can simply use the network by acquiring a Liquid wallet like Blockstream Green. The wallet enables them to send and receive Liquid assets, but they cannot self-verify network activity like Liquid full nodes do.
Who Controls the Liquid Network?
The Liquid Network is governed by the Liquid Federation, comprising more than 60 members.
Federation members are distributed geographically and according to geopolitical considerations across the globe. Anyone can apply to become a federation member as long as they meet the membership criteria. The membership board is in charge of voting for new members. Potential members need three out of five votes in their favor to join the Liquid Federation.
Liquid’s federation has two other boards, each responsible for either oversight or technology. The oversight board is charged with overseeing the network’s status and recommending rules for membership structure and management. On the other hand, the technology board collaborates with Blockstream to build a technical roadmap based on members’ needs.
Besides governance, Federation members can operate bridge nodes, perform peg-out transactions, and purchase the hardware that generates blocks.
Who Has Adopted the Liquid Network?
Several projects are using the Liquid Network to build different applications. Here are three examples of such applications:
Sideswap
Sideswap is a wallet and decentralized trading platform. Users can install the Sideswap app on their phones or computers to manage and trade digital assets on the Liquid Network. Sideswap enables atomic swaps, allowing users to trade tokens without trusted intermediaries. Moreover, users remain in full control over their assets when trading on Sideswap.
Raretoshi
Raretoshi is a marketplace for rare digital art NFTs. It permits artists to create NFT art on the Liquid Network, which collectors can purchase using L-BTC. To get L-BTC, buyers simply need to load their Raretoshi wallets with BTC, which is then automatically converted to L-BTC.
Fuji Money
Fuji Money is a platform that enables users to borrow Bitcoin-backed synthetic assets and stablecoins. The borrowing process entails locking up BTC in a smart contract on Liquid — this Bitcoin acts as collateral for a loan. The smart contract then issues the Fuji asset of your choice, which you can use in leverage trading or swap for other Liquid assets.
How the Liquid Network Helps to Improve Bitcoin
Privacy
In contrast to Bitcoin transactions, which are publicly visible, Liquid transactions offer complete confidentiality. The network facilitates private transactions between two parties, ensuring that the amount transacted and the asset involved remain undisclosed to anyone else. The Liquid Network calls the process of hiding this data from everyone else “blinding.” However, a receiver in a transaction could share the private blinding key with a third party, enabling them to see the amount and type of asset.
Fast Transaction Speeds
Liquid offers faster transaction speeds because it can settle transactions between 2 and 3 minutes when it's working normally. That makes the network faster than Bitcoin, which confirms blocks in an average time of 10 minutes. However, this time could be longer if the network is congested.
Furthermore, Liquid’s finality window is shorter than Bitcoin’s. That’s because a transaction is considered final on Liquid after 2 confirmations. On the contrary, with Bitcoin, the rule of thumb is that finality is reached after 6 confirmations.
Tokenization
The Liquid Network permits users to tokenize fiat, securities, physical assets, cryptocurrencies, and other assets and issue the tokens representing those assets on the Liquid sidechain. Issued assets in Liquid contain human-readable metadata like the name of the token, the ticker symbol, and the asset amount issued.
The Bottom Line
The Liquid Network provides a promising scaling solution for Bitcoin, enabling new use cases to be deployed in the Bitcoin ecosystem with an additional layer of transactional privacy.
While we are yet to witness substantial adoption of this innovative scaling technology, it has the potential to become an integral part of the Bitcoin infrastructure.
FAQs
What is the Liquid sidechain of Bitcoin?
Liquid is a sidechain-based layer-2 solution that seeks to make Bitcoin transactions faster and more private. It also allows the issuance of assets such as stablecoins, security tokens, and NFTs on the Liquid sidechain.
Liquid relies on Bitcoin's security while utilizing an independent consensus model. In this model, a small group of network members called functionaries propose, verify, and sign blocks. They also manage and securely hold the Bitcoin used in the two-way peg. Liquid permits users to move assets to and from the base layer through this two-way peg.
Who is the founder of the Liquid Network?
The Liquid Network was launched in October 2018 by Blockstream, a company co-founded by Dr. Adam Back. Back invented the proof-of-work system, Hashcash. He first proposed the system in 1997 and formally explained it in a 2002 paper. In 2008, Satoshi Nakamoto mentioned Back’s Hashcash in the Bitcoin paper. Adam Back, Eric Svenson, Pieter Wuille, and several other people co-founded Blockstream in 2014.
Blockstream is the technology provider of the Liquid Network, while the Liquid Federation is responsible for governing the network. The federation has over 60 members, consisting of wallet providers, financial institutions, crypto exchanges, digital asset managers, and payment processing platforms.
What is the difference between Liquid and Lightning?
Liquid and Lightning are both Bitcoin layer-2 solutions, but they function differently. Firstly, Liquid processes medium to large transactions, while Lightning is optimized to process micro to small transactions.
Secondly, users interact with Liquid through a two-way peg, where they deposit BTC and receive the equivalent in L-BTC. Conversely, Lightning users interact with the network through payment channels.
Thirdly, Lightning’s settlement speed is almost instant, while Liquid settles transactions in about two minutes.