What it means
A blockchain is a shared ledger that records every transaction in a permanent chain of blocks. Writing each payment to that ledger, which is called an on-chain transaction, gives strong security but can be slow and costly when the network is busy.
Off-chain transactions avoid this by settling the payments elsewhere. The simplest case is an exchange moving coins between two of its own customers.
The exchange just changes the balances in its internal database, and nothing is written to the blockchain. Another method is a payment channel, such as the Lightning Network for Bitcoin, where two parties open a channel with one on-chain transaction, make many payments inside it, and close it with a final on-chain transaction.
The benefits are speed, low fees and privacy for small payments. A business that takes thousands of small payments a day can settle them almost instantly without paying a network fee for each.
Off-chain systems are also used to scale networks that can handle only a limited number of transactions at a time. The risks differ from on-chain activity.
When an exchange holds the coins and keeps the ledger, customers depend on its honesty and security, which is a form of counterparty risk. A failure or hack at the exchange can mean the balances cannot be redeemed, whereas on-chain transfers do not depend on a middleman.
From an accounting and tax view, off-chain transfers still have value and may create taxable events or reporting duties. Finance teams should keep records of each transfer, the counterparty and the fair value at the time.
Rules vary by country and are developing, so professional advice is wise.
In practice
Real-world examples.
Example
A user sends coins to a friend who has an account on the same exchange. The exchange updates both balances in its own records. No blockchain transaction is created and the transfer is complete within seconds.
Example
A coffee shop accepts payments through a Lightning channel opened with a regular supplier. The two parties exchange 200 small payments over a month and settle the net result once. The shop saves most of the network fees it would otherwise pay.
Example
A payments company holds customer cryptocurrency balances in a pooled wallet and records transfers in an internal ledger. Its auditors test the ledger against the amounts held on the blockchain. The test confirms that the company holds enough coins to cover customer balances.
Formula
Calculation
Fee saving = (number of payments x on-chain fee per payment) - (on-chain fees to open and close the channel)
A merchant receives 1,000 small payments from one customer. Each on-chain payment would cost a $2 network fee, so the on-chain total is 1,000 x 2 = $2,000. Using a payment channel, the merchant pays one $2 fee to open it and one $2 fee to close it, so on-chain fees are 2 + 2 = $4. Fee saving = 2,000 - 4 = $1,996, using illustrative fee levels.Case study
Seen in the real world.
Bluewave Payments is a fictional company used to illustrate off-chain transactions. In this illustrative story, it processed 50,000 small cryptocurrency payments a month for online merchants, and each on-chain transfer carried a fee of $1.50. Total monthly network fees were 50,000 x 1.50 = $75,000, which was higher than the margin on some of the payments.
Bluewave moved the payments into an internal ledger and settled with merchants once a day through on-chain transfers. Network fees fell to roughly $3,000 a month, but the company had to invest in security and proof that it held enough coins to cover all balances. It began publishing a regular reconciliation to show customers that their funds were fully backed.
Bluewave also set up a rule that customers could withdraw their coins to the blockchain at any time. The finance team tested this by running a monthly withdrawal drill, which confirmed that the company could honour a large number of requests on the same day.
Watch out
Common mistakes.
- Assuming an off-chain transfer is anonymous or untraceable. The operator of the service usually keeps records, and tax authorities may demand them.
- Treating off-chain balances as if they were held in your own wallet. If a third party holds the coins, you depend on its solvency and controls.
- Ignoring tax and accounting. A transfer can still be a taxable event and needs to be recorded properly.
Questions
People also ask.
What is the difference between on-chain and off-chain?
On-chain transactions are recorded on the blockchain itself, while off-chain transactions are settled outside it, often with only a final record on-chain.
Why are off-chain transactions cheaper?
They avoid the network fee and confirmation time that apply to each separate on-chain transfer.
What is the main risk?
Counterparty risk, meaning the party running the system might fail, be hacked or refuse to honour withdrawals.
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