You may have seen a recent announcement regarding the launch of Blockstream’s new Protocol called “Liquid”. In development since 2015, the Liquid Protocol represents part of a paradigm shift in blockchain. With major networks experiencing scalability and efficiency issues, developers and investors have looked to the potential of layer-2 sidechain based solutions in order to improve usability for a number of major use cases.
Before we get into the operation of the Liquid Protocol, the very simple explanation is that the Liquid Protocol pools bitcoin from multiple sources into a sidechain. This allows instant (or near instant) transfers between Liquid Protocol participants. For the end user, the major benefit of this is instant transfers between different exchanges and financial institutions using blockchains. The protocol also lays the groundwork for a potential cross matching service between exchanges, whereby the liquidity of any Liquid Protocol exchange is accessible by all Liquid Protocol exchanges.
The Liquid protocol’s main function is migrating B2B exchange and institutional based transfers of Bitcoin to a private sidechain, in order to reduce costs and increase speed.
In more specific terms, a sidechain is simply a separate blockchain that is built upon a “parent” blockchain that allows assets from that parent blockchain to be used on that chain. The Liquid Protocol operates as a sidechain, with the Bitcoin network as its parent blockchain. Its native asset, L-BTC (Liquid Bitcoin), is backed by a two-way peg with the bitcoin network, meaning L-BTC can be exchanged for Bitcoin and visa-versa. Additionally, the Liquid protocol aims to include a number of other digital assets, with tokenised versions of Fiat and Commodities in the pipeline.
Initially, the Liquid protocol will provide a faster and more efficient settling platform for Institutional transfers of Bitcoin. Exchanges commonly have to suspend withdrawals and deposits of digital assets during high stress periods because of lacking liquidity of assets. By providing a protocol which allows rapid exchange of assets between exchanges, Liquid should resolve those liquidity issues associated with Bitcoin. An additional advantage to the Protocol is the confidentiality of transactions, something which would not be possible on the public Bitcoin blockchain. Because exchange transfers are typically of a sensitive nature, this provides another advantage for users of the liquid platform.
Whilst Liquid does provide a significant benefit to the institutional ecosystem of Bitcoin, there are some concerns about the level of centralisation it introduces. Blockstream has even admitted that “Liquid is a federated sidechain, so it will never be as decentralized as Bitcoin” (source). In this particular use-case, all of the exchanges included into the protocol currently are centralised exchanges, meaning the centralisation of bitcoin transfers is somewhat less impactful. Nevertheless, the acceptance of more centralisation in exchange for a higher level of performance is becoming more and more common by key stakeholders, with this being something to monitor in the near future.
More generally, the Liquid protocol signals an important transition as investors begin implementing commercially viable sidechain platforms. The potential for similar protocols like Liquid to emerge and improve usability in other use-case areas is significant, as this is a major growth area for major blockchains.