Scaling with Lightning
Dec 2022 Commentary
What a year 2022 has been, and who isn’t glad to put it behind us? Hopes of a pandemic recovery were dashed early with the Russian invasion of Ukraine; supply shocks ensued, sparking global inflation particularly in energy; central bankers deployed their only tool, that of monetary tightening vis-à-vis withdrawing quantitative easing and raising interest rates. Rates, being the fundamental element that prices risk assets, amplify investors’ animal spirits, and rising rates expose the sins of past excesses. December was a continuation of 2022 with global equities dropping over 5% to cap a year of close to a 20% price decline. Inflation in the US started at 7.0%, ended at 7.1%, but that end-to-end perspective belied that strain that consumers felt mid-year when it peaked at 9.1%. The US Fed Funds rate rose 4.25% from near zero to a target range of 4.25% - 4.50% by year-end. The US 10-year yields similarly rose from 1.5% to 3.9%, with the inversion of the 2-year minus 10-year spread indicating a recession and weighing on investors. Long duration growth assets such as the US Nasdaq Index dropped 8.7% over December and 33% in 2022. Specific assets did even worse as indicated by Zoom, the video-conferencing darling of the Covid days, dropping over 63% on the year. Digital assets, beset not only by rising rates but its share of centralized actors employing excessive leverage and committing fraud, shed close to 8% of its market capitalization for the month and 64% for the year.
Whew! Now that we’ve called out that elephant in the room, let’s move on. And as long-term investors in digital assets, we must move on. We remain heartened by what we see – continual infrastructure development to address the core blockchain challenges of scalability, security, and decentralization. In an earlier discussion, we briefly described how improving on these three core characteristics posed a trilemma whereby trying to improve one came at the expense of the others. However, substantial progress has been made over 2022 to address each of these. The Ethereum Merge implemented a more energy efficient consensus mechanism to ensure the security of that blockchain. Layer 2 (L2) solutions, implementing off-chain layers for execution and data, address scalability. Over 2022, much attention has been paid to Ethereum L2 solutions such as Arbitrum and Optimism. Lesser attention has been paid to the Bitcoin Lightning Network and we think this deserves some airtime.
Bitcoin, Slow and Steady, But Not Scalable
Bitcoin is the OG of blockchains and retains its dominant position, capturing around 40% of the market cap of all digital assets. As a workhorse it is a bit slow, to say the least. It can process around 3 to 4 transactions per second (TPS), compared to Ethereum’s 10-20 TPS. These both pale in comparison to Visa which “handles an average of 150 million transactions every day [on average greater than 1,700 TPS] and is capable of handling more than 24,000 transactions per second”.
Bitcoin’s lower TPS is a feature, rather than a bug, of the blockchain’s trustless and permissionless characteristics, secured and accessible in a decentralized manner. Each miner, creating and mining a new block of transactions, is limited by its block size of approximately 1 MB, or ~2700 transactions, and an average block confirmation time of 10 mins. Forked versions of Bitcoin do exist. As an example, Bitcoin Cash allows for larger block sizes to improve upon scalability but while it was relatively easy to fork a platform, it’s been far harder to fork the social consensus that has been built around Bitcoin.
Enter the Lightning Network (LN), an L2 solution that allows for off-chain processing of Bitcoin transactions.
Lightning – Purpose, Principles, and Product
The Lightning Network was conceived by Joseph Poon and Thaddeus Dryja in this seminal 2016 whitepaper (Poon-Dryja) and deployed in 2018. Readers who find the white paper a bit long are invited to explore Andreas Antonopoulos’, a widely respected Bitcoin and blockchain expert, technical introduction on LN.
In summary, Poon-Dryja describes the LN as a “network of micropayment channels” with each channel connecting two parties, and each party being an active address. For the purpose of keeping a “bare minimum of information on the blockchain”, the parties would “[defer] what is broadcast to the blockchain in a single transaction netting out the total balance between those two parties. This permits the financial relationships between two parties to be trustlessly deferred to a later date”.
More precisely, each channel is a multi-signature (multi-sig) electronic wallet whereby a transaction occurs only if the transaction has been signed by both parties in the channel. To activate a channel, one or both parties deposit BTC into the wallet. The size of each deposit is worth the same or more than the value of the transactions that are expected to occur between the two parties. Trust is thereby ensured by economic commitments from both parties and requiring both parties to sign all future transactions.
The transactions are thus simply receipts that may occur multiple times. These transactions occur off-chain as often as needed, contain cryptographic proofs that are only needed if one actor turns malicious, and settle on-chain when either party wants to close the channel. It’s as if you and a friend often buy each other lunch, tracking only receipts and settling the cumulative change once a quarter.
What makes this truly interesting is that, as a network, while any two parties may establish a unique channel to transact with each other, they do not need to do so if they can effectively connect to each other through a daisy-chain of intermediary channels. Several academic studies have pointed out the phenomenon of “six degrees of separation” (here’s one such example), showing that the number of connections between any two points is, on average, quite limited in various social and electronic networks.
Additional technology is implemented on each of the transactions to allow for a properly functioning micropayment network. Hash time lock contracts (HTLC) ensure the proper order of operations to avoid double spending. Preimages or secrets are provided by the transmitter to the recipient to ensure that only the recipient can receive the micropayment. Penalties are enforced such that the violator loses their funds to ensure trustless interactions. Finally, onion routing technology promotes privacy of the micropayment transactions since any one party is only knowledgeable of its sending and receiving counterparties.
Pitfalls, Yet Promises
Cool technology, but is it useful? Pragmatically, bitcoin is not a good medium of exchange given its price volatility. Ideally, one would want a medium that maintains a reasonably stable purchasing power vis-à-vis a basket of commonly used goods and services. One may want to be paid in bitcoin if they believe in its long-term appreciation underpinned by long-term adoption and limited token supply, but in this case, they are likely to hold for the long-term rather than spend it.
Furthermore, by design, the routing fees on the Lightning Network are expected to stay competitive. This, along with the need to dedicate electronic equipment to be a node on the network, limits the economic incentive for the average bitcoin owner. It may drive the network to become a set of channels operated by centralized agents who can reap economies of scale by collecting minimal fees over large amounts of transactions and by enthusiasts.
Agreeing to settle transactions off the books or being the middleperson to transfer funds amongst friends is one thing. Do so at larger volumes and the sums of money will certainly catch the attention of tax authorities, and regulators. This is why banks, money transmitters, and exchanges need to have strong internal compliance procedures to implement know-your-customer (KYC) and anti-money laundering (AML) requirements, retain auditors to examine those procedures, and regularly invite regulators into their offices for reviews. This regulatory moat favors large, centralized agents as well as intentionally anonymous small operators who might ignore regulation completely.
Despite all this doubt and weak bitcoin prices, evidence of adoption of the Lightning Network has been strong. Over the last 3 months, around 17,000 nodes remain online, maintaining up to almost 80,000 channels, holding a capacity of over 5,300 BTC (~ $89 M). Recall that the capacity of a channel refers to the amount of BTC locked in the channels and belies the volume of transactions that is occurring, and that the volume of transactions is impossible to trace with certainty, as these transactions are occurring off-chain. This capacity is up from around 3,300 BTC at the end of 2021 and barely over 1,000 BTC at the end of 2020.
Source: amboss.space. Note that the capacity is measured in satoshis or 0.00000001 BTCs.
The Covid pandemic has upended the way we work, the type of work we do, and the way we interact geographically. Many have chosen to work independently or in small groups to provide creative content be it art, editorials, videos, or podcasts. Similarly, many have chosen to take their payment in this new digital currency known as bitcoin over the Lightning Network.
We should also expect that the current state will not remain static. There are open and proprietary initiatives to make LN technology cheaper and easier to use. As people seek new ways to work, engage, and compensate, they may form a collective voice that should drive governments to change their regulations and legislations. Developments are happening at lightning speeds and the LN should not be dismissed.