This is an opinion editorial by Shinobi, a self-taught educator in the Bitcoin space and tech-oriented Bitcoin podcast host.
Federated sidechains are currently the only deployed type of Bitcoin sidechain (the most recent paper here). The idea of using a federated peg and consensus system was actually an appendix in the original sidechains whitepaper. There was no concrete design for any type of two-way peg involving miners, so a federated peg was described as a way to deploy a sidechain now, and upgrade to a two-way verified peg using simple payment verification (SPV) proofs similar to what softchains do, when something was concretely designed that was safe and deployable. It was also pointed out that in terms of incentives, for very small systems it might be dangerous to use a miner-based peg as they could steal from a very small group of people without much consensus on doing anything about it from the wider Bitcoin system. Federations could be useful for smaller systems where the group of users isn’t big enough to be a disincentive for miners to steal coins.
The general idea is to effectively have a blockchain where a selected group of trusted parties custody bitcoin pegged into the system using multisig, and produce the blocks on the sidechain, signing them with cryptographic keys instead of using proof-of-work. The entire security model is based on having a decently large set of distinct participants in the group, or federation, that are very geographically distributed and are publicly known.
Federations use a threshold of members for both the custody of bitcoin on the mainchain and blocksigning, i.e., a 5-of-7 multisig. This is done instead of requiring all seven of the members to sign in order to balance the two major risks of such a system: theft versus loss. The federation together can steal all of the funds locked in a federated sidechain if they choose to cooperate together to do so; this is why the entire security model is based around many…
