Federated Sidechains
Understanding sidechain technology and federation models
What are Sidechains?
A sidechain is a separate blockchain that runs in parallel to a "main" blockchain (like Bitcoin) and is connected to it through a two-way peg mechanism. This allows assets to be transferred between the chains while maintaining a cryptographic link between them.
Sidechains were proposed as a way to extend blockchain functionality without modifying the main chain, allowing for experimentation with new features, different consensus mechanisms, or specialized use cases while inheriting security from the parent chain.
The Liquid Network is an implementation of a federated sidechain for Bitcoin, where the security model is based on a federation of trusted entities rather than proof-of-work mining.
The Two-Way Peg
The two-way peg is the mechanism that allows assets to move between the main chain and the sidechain. In Liquid, this enables Bitcoin to be transferred to the Liquid Network (becoming L-BTC) and back again.
Peg-in (Bitcoin → Liquid)
When a user wants to move Bitcoin to Liquid, they send BTC to a special federation-controlled multisignature address. Once confirmed, the federation creates an equivalent amount of L-BTC on the Liquid sidechain and sends it to the user's Liquid address.
- User creates a Liquid address for receiving L-BTC
- User requests a federation-controlled Bitcoin address
- User sends BTC to this federation address
- After Bitcoin confirmation, federation creates equivalent L-BTC
- L-BTC is sent to the user's Liquid address
Peg-out (Liquid → Bitcoin)
To convert L-BTC back to BTC, users initiate a peg-out transaction on Liquid. After verification, the federation releases the equivalent amount of BTC from its reserve to the user's Bitcoin address.
- User initiates a peg-out transaction on Liquid
- User specifies their Bitcoin address for receiving BTC
- Transaction is verified by the federation
- Federation burns the L-BTC from circulation
- Federation releases BTC to the user's specified address
Note: Currently, only federation members can initiate peg-outs directly. Regular users must go through a federation member to peg-out their L-BTC.
A Note from Satoshi
Federation Model
The Liquid Federation is a group of cryptocurrency businesses and financial institutions that collectively manage the network. This model differs significantly from Bitcoin's trustless proof-of-work consensus.
Security Model
The federation secures the network through a threshold signature scheme. To sign blocks and authorize transactions, a supermajority of functionaries must provide their key shares. This distributes trust across multiple entities.
Functionaries
Functionaries are the servers operated by federation members that run the Liquid software. They hold key shares that are combined to create signatures authorizing blocks and transactions. No single functionary has a complete key.
Fault Tolerance
The federation is designed to be fault-tolerant. Even if some functionaries go offline or are compromised, the network can continue operating as long as a sufficient threshold of honest functionaries remains active.
Consensus
Liquid uses a federated consensus mechanism called Strong Federations, where block production is rotated among functionaries. Blocks are only valid when signed by the threshold number of functionaries.
Federation Members
The Liquid Federation consists of diverse members from the cryptocurrency ecosystem, including:
- Cryptocurrency exchanges (Bitfinex, BitMEX, etc.)
- Financial institutions focused on digital assets
- Bitcoin infrastructure companies
- OTC trading desks
- Cryptocurrency service providers
These members have a vested interest in the integrity of the Liquid Network, as they use it for their operations and services. This alignment of incentives helps ensure the security and reliability of the network.
Advantages and Tradeoffs
Advantages
- Faster block times (1 minute vs. Bitcoin's 10 minutes)
- Predictable settlement finality
- Energy efficiency compared to proof-of-work
- Ability to implement features not possible on Bitcoin
- Simplified governance model for network upgrades
Tradeoffs
- Requires trust in the federation (vs. Bitcoin's trustlessness)
- More centralized than Bitcoin's open mining system
- Potential regulatory pressure on federation members
- Peg-out restrictions for non-federation users
- Risk of collusion among federation members
A Note from Satoshi
Comparing Consensus Models
| Feature | Bitcoin (PoW) | Liquid (Federation) |
|---|---|---|
| Block Time | ~10 minutes | ~1 minute |
| Finality | Probabilistic (6+ confirmations) | Deterministic (2 confirmations) |
| Security Model | Economic (51% attack) | Trust-based (2/3 threshold) |
| Participation | Open to anyone | Limited to federation members |
| Energy Usage | High | Low |
| Censorship Resistance | Very High | Moderate |
| Governance | Highly decentralized | Federation-driven |