Sidechains and the Future of Bitcoin
Bitcoin’s Missing Piece
One of the main criticisms of the bitcoin protocol is that it is limited to the transfer of bitcoin itself, that it lacks an openness and scalability to encourage the development of new use cases utilizing the underlying technology – so-called “bitcoin 2.0”. The bitcoin core developers would argue that it is this singularity of purpose, this keeping it simple, that maintains the integrity of the protocol. Bitcoin does one thing and it does it well. However, this limitation has led to the proliferation of altcoins – both alternative blockchains and upper level protocols – that while spurring innovation, have also had negative effects.
Dr. Adam Back, widely unknown outside of the cryptography community, has as much to do with the rise of Bitcoin as anybody. In 1997, he invented a system known as hashcash which was meant to curtail email spam and denial of service attacks. As it pertained to email, hashcash was an algorithm requiring senders to exert a bit of power to make a special calculation, the validity of which could easily be checked by recipient. For one email, no problem; as it pertained to spam, the thought was that the energy expended would make it unprofitable. Hashcash has become better known as the mining algorithm at the very foundation of the bitcoin protocol.
In June of 2015, Dr. Back announced that his company Blockstream would release open source code for developers to experiment with sidechains (read the whitepaper here). Sidechains might be thought of as branches, connected and interoperable with the main blockchain, using bitcoin as their base currency. Sidechains offer the ability to do one of two things (or both). They can power alternative technological applications like smart contracts, or they can employ alternative mining methodologies to offer, for instance, greater transaction speed required to support anti-spam measures, file storage monetization or even the Internet of Things.
Each sidechain possesses a unique token necessary for transacting within it – these tokens are pegged to bitcoin with a 100% correlative value. Bitcoin moves to and from sidechains by a method known as two-way pegging. To purchase tokens and utilize the services offered by any particular sidechain, bitcoins are sent to a designated wallet known as a lockbox. After cryptographic proof of the transaction has been offered by the main blockchain, the sidechain network releases a correlating number of tokens to the user. Once the owner of a token would like to restore his bitcoin, there is a process by which the equivalent token value is destroyed, and the bitcoin is released back to a user’s wallet on the main blockchain. This ensures that sidechains never have the unintended effect of accidentally increasing the amount of bitcoin on the main chain.
The sidechain advantage
While many might disagree, one of the largest advantages of a successful sidechain is that it will most likely kill the altcoin market. It is here that our bitcoin-centric biases come into full light, but it is our opinion that in the long run altcoins will have a negative effect on the wider cryptocurrency market. That is not to say that certain altcoins have not been directly and solely responsible for incredible innovation, and many of the world’s brightest minds and top developers are working earnestly in the altcoin market – Vitalik Buterin and Ethereum immediately come to mind. However, it will be nigh on impossible for even the best alternative networks to generate coins with sustained and relatively stable value. And a sustained and stable underlying unit of value is necessary for the mass adoption of any cryptocurrency-based technology. Bitcoin has already fought this fight; adoption, demand and value have already been established; network stability has been proven; the mining infrastructure is massive and dedicated.
In the best of cases, altcoins offer value but serve to fragment the cryptocurrency market, sapping sorely needed liquidity from the bitcoin network. And of course, not all altcoins are created in the spirit of innovation or productive capitalistic pursuit. Altcoin prices are easy to manipulate. Many coins have been pumped up with false or exaggerated claims circulated by insiders with massive positions, only to crash once the castle is shown to be made of sand – but not before being dumped on enthusiastic members of the altcoin marketplace.
A robust sidechain market will pull liquidity back into the bitcoin network from the various altcoins. More importantly, sidechains could expand demand exponentially from outside the current cryptocurrency market. There is the potential for a massive number of alternative use cases, and it is not difficult to dream up applications appealing to almost any demographic segment. And while in the future these demographic segments might not even be aware of the fact that bitcoin is being utilized to power whatever service they are using, it will be, and this should have great affect on demand and value.
Of course, sidechains are not without their weaknesses.
A main consideration in the sidechain project is that the integrity of the main blockchain – from security, performance and money supply perspectives – is maintained. The blockchain will never allow the reentry of bitcoin into the bitcoin blockchain that is not represented by a predetermined amount of pegged sidechain tokens being destroyed. This means that, if there were to be some sidechain breach resulting in artificially inflated token amounts, it would be a race to withdraw the corresponding bitcoin. Those not quick enough to exit the sidechain would be stuck with worthless tokens in a collapsed sidechain. It is the mining methodology employed by each sidechain that is meant to defend against such a scenario.
There are two potential mining security solutions, neither entirely satisfactory. Overshadowing both is the question of miner compensation, remembering that sidechain tokens are pegged at 100% correlative value to the bitcoin located in the sidechain lockbox. Thus, a similar reward mechanism to that of bitcoin mining is not possible.
The first security solution, and preferable for most sidechains, is called merged-mining, in which sidechain transactions are included within the main blockchain and mined alongside standard bitcoin transactions. This is particularly attractive because the exact same proof of work done for bitcoin can be applied to the sidechains with no additional energy expense. Miners can opt in/opt out of including sidechains into their transactional blocks. This means that merged mining difficulty level is less than or equal to the difficulty level of bitcoin. In the case that much of the bitcoin mining network opts out, the sidechain would be susceptible to a 51% attack in which a miner with massive power simply verifies blocks with its own double spent tokens.
A 2012 attack on an altcoin named “Coiled Coin” can help illustrate how this would happen. Coiled Coin cloned the bitcoin technology and added an additional feature “borrowed” from an upcoming bitcoin release, thus essentially stealing bitcoin core devs intellectual property and pawning it off as his own.. Perhaps for the noble purpose of protecting the public from an obvious pump and dump scheme, a miner named Luke Jr. destroyed the coin by diverting massive mining power to it and continuously “solving” blocks with zero transactions, thus halting the verification of actual transactions. The same mechanism could be deployed on a sidechain not supported by a good amount of mining power.
The second solution is to employ alternative methods of blockchain proofs not entirely dependent on computational power. Examples of alternative methods can be found in peercoin’s proof of stake, bitshares delegated proof of stake or even Ripple’s centralized ledger system. Of course alternative proofs, while perhaps offering different advantages like quicker transaction settlements, disconnect the sidechain from the strength and stability of bitcoin’s mining infrastructure.
In either solution, there are a few methods for miner compensation. First, transaction fees can be charged and offered to successful miners as a reward. This is particularly attractive in the merged mining scenario, as this presents only upside for the existing bitcoin mining network, no matter how small the commercial upside might be. An alternative method, called demurrage, charges users a fee for holding and storing their tokens on the side chain, and this fee is distributed amongst miners based on their contribution.
There will most likely be dissent on the part of some very worthy developers over the sidechain project, in large part due to their intellectual and reputational investment in altcoin projects. However, if sidechains deliver the goods, it is hard to envision many alternative networks surviving – with perhaps the notable exception being Ethereum, who has got a shot. Of course, many complementary technologies – like factom, tether and counterparty – will survive the ensuing carnage and integrate in one form or another directly as sidechains.