Comprehensive Depth Research Report: In-depth Analysis of off-chain Scalability

Authors: Ellaine Xu, Hettie Jiang, June Wang, Walon Lin, Yiliu Lin

1. The Necessity of Scaling

The future of blockchain is a grand vision: decentralization, security, and scalability; but usually blockchain can only achieve two of these, and meeting all three requirements is known as the impossible triangle problem of blockchain. For many years, people have been exploring how to solve this dilemma, how to improve the throughput and transaction speed of blockchain while ensuring decentralization and security, that is, solving the scalability issue, which is one of the hot topics discussed in the current blockchain development process.

Let's first broadly define the decentralization, security, and scalability of blockchain:

• Decentralization: Anyone can become a node to participate in the production and verification of the blockchain system. The more nodes there are, the higher the degree of decentralization, thus ensuring that the network is not controlled by a small group of large centralized participants.
• Security: The higher the cost of gaining control over the blockchain system, the higher the security, and thus the chain can resist attacks from a larger proportion of participants.
• Scalability: The ability of a blockchain to handle a large number of transactions.

The first major hard fork of the Bitcoin network was due to scaling issues. As the number of Bitcoin users and transaction volumes increased, the Bitcoin network, with a block size limit of 1MB, began to face congestion problems; starting in 2015, there were differences in the Bitcoin community regarding the scaling issue. One side, represented by Bitcoin ABC, supported expanding the block size, while the other side, represented by Bitcoin Core, believed that the Segregated Witness (Segwit) solution should be used to optimize the main chain structure. On August 1, 2017, Bitcoin ABC launched its client system, developed to 8MB, resulting in the first major hard fork in Bitcoin's history, which also led to the birth of a new cryptocurrency, BCH.

Similarly, the Ethereum network has chosen to sacrifice some scalability to ensure the security and decentralization of the network; Although the Ethereum network does not limit the volume of transactions by limiting the block size as the Bitcoin network does, but instead sets a cap on the gas fees that can be accommodated in a single block, the purpose is to achieve Trustless Consensus and ensure a wide distribution of nodes ( whether the limit is removed or increased will eliminate many smaller node ) with insufficient bandwidth, storage, and compute.

From the emergence of on-chain applications like CryptoKitties in 2017, DeFi summer, to the later rise of GameFi and NFTs, the market's demand for throughput has been continuously increasing. However, even the Turing-complete Ethereum can only handle 15 to 45 transactions per second ( TPS ), which results in rising transaction costs, longer settlement times, and makes it difficult for most Dapps to bear operating costs. The entire network has also become slow and expensive for users, highlighting the urgent need to resolve the blockchain scalability issue. The ideal scaling solution is to improve the transaction speed of the blockchain network ( shorter finality time ) and transaction throughput ( higher TPS ) without sacrificing decentralization and security.

2. Types of Scalability Solutions

We categorize the scalability solutions into two main types: on-chain scalability and off-chain scalability, based on the standard of "whether to change a layer of the mainnet".

2.1 On-chain Scaling

Core concept: a solution to achieve scalability by modifying a layer of the mainnet protocol, with the current main solution being sharding.

There are various solutions for on-chain scalability, this article will not elaborate on them, and briefly lists two solutions below:

• Option one is to expand the block space, which means increasing the number of transactions packed into each block. However, this will raise the requirements for high-performance node devices, increase the entry threshold for nodes, and reduce the degree of "decentralization".
• Solution two is sharding, which divides the blockchain ledger into several parts. Instead of each node participating in all accounting, different shards, or different nodes, are responsible for different accounting. Parallel computing can handle multiple transactions simultaneously; this can reduce the computational pressure on nodes and lower the entry threshold, improving transaction processing speed and the degree of decentralization. However, this means that the computing power of the entire network is distributed, which may reduce the overall "security" of the network.

Changing the code of a layer 1 mainnet protocol can have unpredictable negative impacts, as any slight security vulnerability in the underlying system can severely threaten the overall security of the network, potentially forcing the network to fork or interrupt for repair upgrades. For example, the inflation vulnerability incident of Zcash in 2018: Zcash's code is modified based on Bitcoin version 0.11.2, and in 2018, an engineer discovered a high-risk vulnerability in its underlying code, namely that tokens could be minted infinitely. The team then spent 8 months secretly patching it, and only disclosed the incident after the vulnerability was fixed.

2.2 off-chain scaling

Core Concept: A scaling solution that does not change the existing Layer 1 mainnet protocol.

Off-chain scalability solutions can be further divided into Layer 2 and other solutions:

3. Off-chain Scaling Solutions

3.1 State Channels

3.1.1 Overview

State channels stipulate that users only need to interact with the mainnet when the channel is opened, closed, or disputes are resolved, placing user-to-user interactions off-chain to reduce the time and monetary costs of transactions for users, while allowing for unlimited transaction frequency.

State channels are simple P2P protocols suitable for "turn-based applications", such as a two-player chess game. Each channel is managed by a multi-signature smart contract running on the mainnet, which controls the assets deposited into the channel, verifies state updates, and arbitrates disputes between participants ( based on fraud proofs with signatures and timestamps ). After the contract is deployed on the blockchain network, participants deposit a sum of funds and lock it in; once both parties sign to confirm, the channel is officially opened. The channel allows for an unlimited number of off-chain free transactions ( between participants as long as their net transfer value does not exceed the total amount of tokens deposited ). Participants take turns sending state updates to each other, waiting for the other's signature confirmation. Once the other party signs to confirm, the state update is considered complete. Normally, state updates agreed upon by both parties are not uploaded to the mainnet; they only rely on mainnet confirmation in the event of a dispute or when closing the channel. When it is necessary to close the channel, either participant can propose a transaction request on the mainnet, and if the exit request receives unanimous signature approval, it is executed on-chain immediately, meaning the smart contract distributes the remaining locked funds based on the final balance of each participant in the channel; if other participants do not sign to approve, everyone must wait for the "challenge period" to end before receiving the remaining funds.

In summary, the state channel solution can significantly reduce the computational load on the mainnet, increase transaction speed, and lower transaction costs.

3.1.2 Timeline

• In February 2015, Joseph Poon and Thaddeus Dryja published the draft of the Lightning Network white paper.
• In November 2015, Jeff Coleman systematically summarized the concept of State Channels for the first time, proposing that the Payment Channel of Bitcoin is a sub-case within the concept of State Channels.
• In January 2016, Joseph Poon and Thaddeus Dryja officially published the white paper "The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments" which proposed the scalability solution for the Bitcoin Lightning Network Payment Channel( payment channel). This solution is only used for processing transfer payments on the Bitcoin network.
• In November 2017, the first design specification for State Channels based on the Payment Channel framework, called Sprites, was proposed.
• 2018/06, Counterfactual proposed a very detailed Generalized State Channels design, which is the first design completely related to state channels.
• In October 2018, the article Generalised State Channel Networks introduced the concepts of State Channel Networks and Virtual Channels.
• In February 2019, the concept of state channels was expanded to N-Party Channels, and Nitro is the first protocol built on this idea.
• 2019/10, Pisa expanded the concept of Watchtowers to address the issue of all participants needing to be continuously online.
• 2020/03, Hydra proposed Fast Isomorphic Channels.

3.1.3 Technical Principles

The general workflow of state channels:

1. Alice and Bob deposit funds from their personal EOA to the on-chain contract address, and these funds are locked in the contract until the channel is closed, at which point the balance is returned to the user; after both parties sign and confirm, the state channel between them is officially opened.

2. Alice and Bob can theoretically conduct an unlimited number of transactions off-chain through this channel, with participants communicating with each other via encrypted signed messages ( instead of communicating with the blockchain network ). Both users need to sign each transaction to prevent double-spending malice. Through these messages, they propose their account state updates and accept the state updates proposed by each other.

3. If Alice wants to close the channel and end the transaction with Bob, Alice needs to submit the final state of her account to the contract. If Bob signs to approve, the contract will release the locked funds back to the corresponding user according to the final state. If Bob does not respond with a signature, the contract will release the locked funds back to the corresponding user after the challenge period ends.

3.1.4 Advantages and Disadvantages

Advantages:

• Instant finality
• Low cost
• High Privacy
• No need to trust a third party

Disadvantages:

• Requires multiple online sessions
• Unable to process large-scale withdrawals
• Funds need to be locked in advance.
• Not suitable for complex applications

3.1.5 Application

Bitcoin Lightning Network

Overview: The Lightning Network is a small payment channel in the Bitcoin network, and its overall technological evolution has experienced: 2/2 multi-signature construction of unidirectional payment channels, the addition of RSMC ( Revocable Sequence Maturity Contract ) allows for the construction of bidirectional payment channels, and the further addition of HTLC ( Hash Time Lock Contract ) enables the connection of payment channels to expand to multi-party payments, ultimately constructing the payment network known as the Lightning Network. Through off-chain small payment channels, and then utilizing intermediaries to form a transaction network, it can solve the scalability problem of the Bitcoin network. The overall usage of the Lightning Network follows the process of "Deposit ( Establish Channel ) → Lightning Network Transaction ( Update Channel Status ) → Refund/Settlement ( End Channel )"; theoretically, the Lightning Network can process one million transactions per second.

Timeline:

• In February 2015, the draft of the white paper was released.
• In January 2016, the official version of the white paper was released and Lightning Labs was established.
• In March 2018, the first mainnet version was released.
• In 2021, multiple exchanges supported El Salvador's adoption.
• In 2022, further develop the ecosystem.

Ecological Development:

• Base layer: BTC network
• Core Infrastructure: Lightning Network Solutions, Nodes, and Liquidity Services
• Upper-layer applications: payment, financial services, and various applications

Ethereum Lightning Network

Overview: The Lightning Network is a micropayment channel built on Ethereum, similar to the Lightning Network, aimed at achieving near-instant, low-cost, and scalable ERC20 token payments.

Timeline:

• Established in 2017
• October 2017 ICO
• Mainnet launched in May 2020
• At the end of 2021, multiple exchanges delisted tokens.

Currently not widely adopted, reasons include:

1. High barrier to entry
2. has appeared earlier