Liquid Sidechain Halted After 4,000 Bitcoin Pegged Out Through an Inflation Bug

Blockstream paused the Liquid Network on Sept. 6 after roughly 4,000 bitcoin left the federation wallet that backs L-BTC, the pegged bitcoin token that circulates on the sidechain. CoinDesk valued the withdrawal at about $320 million and reported that the settlement layer, used by exchanges and traders to move bitcoin faster than the base chain allows, stopped processing transactions. Bridge nodes were disabled and exchanges were asked to suspend L-BTC deposits and withdrawals, Bitcoin Magazine reported.

The attack path was not a stolen key. Preliminary accounts point to an inflation defect in Elements, the open-source software Liquid runs, which allowed the creation of more than 4,000 L-BTC that no bitcoin backed. Those tokens were then redeemed through an ordinary peg-out. Because the redemption satisfied the consensus rules as the software implemented them, the hardware security modules held by federation members signed the bitcoin transaction. Blockstream's public proof-of-reserves page showed federation holdings falling from more than 4,200 bitcoin to just over 200.

The people holding the coins have communicated in public. They moved funds and attached messages in the arbitrary-data field of bitcoin transactions, first stating that they are ethical hackers and asking to be contacted on-chain, then supplying a Signal handle. A reply transaction, presumed to come from Blockstream, carried a contact address. Watcher Guru reported that the group intends to return the bitcoin once the vulnerability is fixed, and Cointelegraph reported that Liquid described the withdrawal as the work of people claiming to be ethical hackers. No return has been confirmed.

Two interpretations of these facts are possible, and neither can yet be ruled out. If the group is genuine, the on-chain messages are the cheapest way to open negotiation and secure a fee. If it is not, the same messages delay a reckoning while the market decides what unbacked L-BTC is worth. What this incident makes clear is the trust model underneath it: L-BTC holders were never exposed to Bitcoin's consensus, they were exposed to a federation's software and its signing policy, and one defect in that software converted a claim on 4,200 bitcoin into a claim on roughly 200.