Bitcoin Series 28: Sidechains


I met Austin Hill, one of the founders of Blockstream in April and he messed with my mind a bit talking about pegged sidechains.  So I have been waiting for the formal announcement to come out so I can write about it. 

I am going to simplify the technical side and focus on the practical implications.    The basic concept technically is that pegged sidechains allow you to:

1. Lock up some bitcoins on the main Bitcoin blockchain

2. Make that corresponding value appear on another blockchain (the 'sidechain') that might have different characteristics than the Bitcoin blockchain

3. Engage in transactions on the sidechain

4. Optionally, exit back to the Bitcoin blockchain to 'cash out' so to speak.  

For this to work, it will require a smallish change to the Bitcoin blockchain in the form of a soft fork that will have to be accepted by leading miners.  For the purposes of this post, let's assume the change is made at some point in the future.

What are likely usage cases?

1. The main point that is highlighted is that sidechains eliminate the need for alt-coins to develop their own market / currency liquidity in order to test a new blockchain concept (aka, 'faster transactions', 'different monetary policy', 'better privacy', 'more extensive scripting', 'contracts', 'different cryptography', 'different mining models' and so on).   This is a good thing overall, as I believe as it is not plausible that we will have as many liquid blockchain currencies as we will have ideas to test. Getting a cryptocurrency to critical scale is a tough process.  Even Bitcoin itself is no more than 1-5% of the way there, and alt-coins are nowhere close to being ready...  

So, this allows a developer/team that is interested in a different blockchain policy to piggyback on the currency/liquidity/market access of bitcoin to be able to pull value in and out of their blockchain.  Now, they still need to provide some security within their own sidechain, but that may or may not be relevant given the usage case.  If, for example, I wanted to make an ultra-low transaction fee, ultra-fast confirming blockchain for ultra-micro-payments, then transaction security on the sidechain is a lower priority, as the amounts at risk are very small.   

2. While the above is interesting, I think the Blockstream team is burying the lede a bit in their announcements by focusing mostly on alt-coins.  I think the bigger opportunity here has to do with other assets altogether (aka, colored coins) and markets that have different levels of openness (from fully open/decentralized to guaranteed by trusted counterparties to private marketplaces).   Illustratively:

a. A blockchain focused on trading real estate titles

b. A blockchain that works with fractional reserves among semi-trusted parties.   AKA, move in $1 worth of bitcoin to be able to exchange $5 worth of [other assets]

c.  A blockchain with 20 investment banks trading 'instrument X' where counterparty risk is handled outside the blockchain, and the blockchain is used for settlement.

And so on

What Does This Mean?

I think there are several implications *if this works*:

1. I think it is unavoidable that it will increase the market value of bitcoin as larger amounts of value will need to be pushed through bitcoin into the sidechains.   While some sidechains might work on a fractional reserve system, not all will.

2. For the sidechains to get to any serious scale, they will need some hashing power or other proof-of-work scheme.   Blockstream proposes merged mining as an approach, but you might see marketmakers in sidechains needing to bring mining power online as part of their contribution.

3. Bitcoin exchange rate stability with sovereign currencies (something that I expect will come in time) will become relevant as you need it to get value out of the sidechain (in most sidechains that I can imagine).   Otherwise, you could have successful transactions on the sidechain only to discover that your ability to cash out back to sovereign currency is impacted by bitcoin exchange rate moves.

In aggregate, if you think about these conditions, they are reflect a world of a vastly more powerful, extensive and valuable Bitcoin network and bitcoin currency.  Blockstream is fundamentally a very bullish bet on Bitcoin.

Further Reading:

1. The Blockstream paper (fairly technical)

2. @gendal's brief explainer (not technical)

For the full bitcoin series:
Twitter: @polemitis and @ledracapital

Posted on November 1, 2014 .