Blockchain Scaling: On-Chain Vs. Off-Chain

Blockchain and related technologies represent a fundamental breakthrough in computer science. In the future, we will look back and see these breakthroughs as catalysts that unlocked endless human potential. The printing press, the steam engine, the internet and blockchain technology.

Having said that, we are still in the early days of this revolution. In order for the technology to reach its full potential, scalability challenges need to be addressed. Frankly, we still have a long way to go before blockchain is used in the daily lives of seven billion people.

In this paper, we will explore blockchain scalability from two perspectives: on-chain scaling and off-chain scaling. We will explore the merits of each approach and what we will end up with in the future.

Scaling blockchains is a challenge
Firstly, it is important to determine how far the blockchain will actually scale. Essentially, a blockchain is a time-dependent distributed database. Each computer (node) in the network must keep a copy of the ledger. This redundancy reduces the risk of corruption by any individual or group in the network.

A trade-off with a distributed system is that because each computer must keep a copy of the database, this limits the throughput of the system. Essentially, the system can only process transactions as fast as any one computer.

Most existing blockchains are designed with the idea of hindsight in mind. Instead, blockchains like Bitcoin choose to priorities features such as security, decentralization, invariance and censorship resistance.

There are two main approaches to scaling blockchains: improving the base layer blockchain (on-chain scaling) or a layered approach with multiple protocols working in tandem (offline scaling).

Let's take a look at the pros and cons of each approach.
Advantages and disadvantages of on-chain scaling
The on-chain scaling approach consists of improving the throughput of the base layer of the network. For existing chains, this means improving the latency of the peer-to-peer (p2p) layer, reducing the size of transactions and messages, etc. An example of successful on-chain scaling is Bitcoin's implementation of isolated witnesses as a soft fork. segWit reduces the size of Bitcoin transactions that end up being permanently stored in the blockchain.

Unfortunately, scalability improvements to the existing blockchain base layer are unlikely to achieve the level of scalability required to reach a mainstream global audience. Even if Bitcoin were to increase its grassroots scalability by a factor of 10, it would still not be able to meet the needs of the global economy's payment methods. This is why Bitcoin is focused on "off-chain scaling", which we will describe below.

If we extrapolate Bitcoin's base layer scalability limits into the future, most transactions will likely occur on the second layer, which does not have the same security guarantees as on-chain transactions.

This could lead to a situation where only banks, corporations and the wealthy can afford to chain bitcoin transactions. At the same time, the majority of people in developing countries cannot afford the high cost of chain transactions. Arguably, the majority (of developing countries) would need to censor the boycott and areas of hard currency would be priced out of on-chain bitcoin transactions.

Another way to radically improve on-chain scaling is to create a new network that uses a new consensus mechanism that prioritizes scaling over other features that may be needed. Ideally, this approach would provide on-chain transactions for the average person. This means finding alternatives to existing consensus mechanisms such as proof-of-work (Bitcoin), proof-of-stake (Ether 2.0) or proof-of-delegation (EOS).

Advantages and disadvantages of off-chain extensions
Off-line scaling means creating alternative protocols that live "on top" of the blockchain. These protocols unlock new capabilities for digital assets with different design trade-offs. For reference, our current internet is built in layers.

Layered extensions are supported by Gall's Law, which states.
"A valid complex system is always found to have evolved from a valid simple system. A complex system designed from scratch will never work and cannot be patched to make it work properly. "
Bitcoin's Lightning Network is the most prominent off-chain scaling solution on the market.

Lightning Network is a clever solution that uses payment channels to defer settlement to the grassroots level. It provides a trustless way to process Bitcoin transactions quickly and cheaply, but does not provide the same security guarantees as on-chain transactions. The Lightning Network is only 18 months old and there are many challenges ahead.

Lightning Network's Downside #1: The Time Value of Capital
In order for Lightning Network to be successful, a large amount of liquidity needs to be locked up in the network. In other words, users need to keep their bitcoins on the Lightning Network in order to make them available for routing payments. The question is, will people decide to keep their bitcoin funds on the Lightning Network rather than have its "work" elsewhere for a greater return? Without high liquidity, there is a risk that the network will become concentrated or unable to support a mainstream user base.

Lightning Network's Downside #2: Businesses and Governments Won't Like It
The Lightning Network offers users a higher level of privacy when dealing with Bitcoin. This is great for individuals, but governments and corporations don't want their citizens to deal privately. Instead, our largest institutions support "watchdog capitalism". In other words, they benefit from spying on their citizens and customers. Governments and large corporations protect their interests and may attack Bitcoin in the future in a regulatory stance.

Blockchain solutions are just getting started
So far, we have seen incredible progress in the blockchain industry. Bitcoin has proven to the world that we have created a new form of currency that is not controlled by governments or any other entity.

However, just because we have seen some mild success doesn't mean we should stop working on new solutions with potentially better trade-offs. In fact, we still have a long way to go before the industry matures. It's time to build. The sky's the limit.