Will the Lightning Network Save or Destroy Bitcoin?

The Lightning Network has been heralded as the way to scale Bitcoin into the future, but as two separate camps of opinion on increasing Bitcoin’s transaction capacity begin to draw lines between themselves, it’s worth looking at this technology with a pragmatic eye, assuming that once adopted, it will be hard for the community to find a way back¹.

First, I would like to say that the Lightning Network as an idea is quite interesting. I think it will have many uses in the Bitcoin world. Yes, I have read the whitepaper (both the long version and the short version) and I believe I have a good understanding of how it works. Disclaimer: Since most of the development is done behind closed doors by Bitfury, it is difficult to comment on any new unreleased developments, such as the development of routing algorithms.

Time benefit risk analysis!

Let’s analyze the pros and cons of the Lightning Overlay Network.

1. Unlimited txn/s;

2. Ensure that there is no double spending;

3. Requires the use of Bitcoin;

The first and greatest feature of the Lightning Network is that it allows for any number of txns to be sent between parties without ever touching the Bitcoin blockchain. This means that, in theory, if you and I open a channel and each of us has 10 BTC, then any amount of payments between us that would result in me having 20 BTC and you having 0 BTC, or vice versa, can be done completely off-chain. Furthermore, these two-way channels can be chained together to act as a bridge between people who don’t have open direct payment channels. This is great for scaling peer-to-peer transactions between parties that you pay on a daily basis (your utility company, the Starbucks at your workplace). What’s not clear in this context is how much of a connection the payer and payee need to have in order to get money from anyone to anyone else without using a centralized clearinghouse (hub). A payment hub simply opens a deposit channel, and the client deposits 100% of the BTC (the hub doesn’t provide anything), because when the client wants to withdraw the money from the new channel, the channel funds must be 100% reserved before they can be withdrawn, and the channel funds may be set to a maximum withdrawal amount per month. Sound familiar? It should be, because it’s how your bank works today

Second, the Lightning Network solves the double-spending problem by cleverly exchanging cryptographically signed commitments to Bitcoin. Double spending is prevented by providing counterparties in a channel with the ability to revoke the entire channel and invalidate all funds if they attempt to cheat by publishing an invalid state of the channel (e.g., a prepaid amount that has already been paid).

Third, the Lightning Network requires some valuable tokens to be “locked” in the channel in order for the channel to be valuable. Currently it is based on Bitcoin, which means that as a secondary effect it will require more people to buy BTC and use it in the channel. This has the potential to increase Bitcoin’s user base somewhat. While the LN developers also mentioned that it is easy to replicate on Ethereum or any other cryptocurrency, they did not rule out doing this work for blockchains in the future. Perhaps even using the LN as a bridge between blockchains as a decentralized exchange or peg mechanism. (A channel with BTC on one end and ETH on the other is theoretically possible)

Now for the negatives and their trade-offs:

1. Scaling to unlimited txns would technically work, but it does not scale for users.

2. Compared to Bitcoin, has an inverted security model.

3. Bitcoins are locked and encrypted in channels, which affects the interchangeability of Bitcoins.

4. It is conducive to the centralization of payment centers (hubs).

So first, the notion that infinite txn scaling will solve all problems is a mistake. It doesn’t. Because every LN channel opening/closing means a (slightly stronger) txn on the Bitcoin blockchain, an interesting effect is that the on-chain scaling problem becomes a two-layer interaction problem, where the bottleneck problem of on-chain transaction volume becomes the bottleneck problem of how many payment channels can be opened or closed on-chain. This creates an interesting situation, if LN txns are scaled to include the entire world’s worth of daily transactions (the often touted “VISA” standard), then this will become a problem if for any reason a large number of payment channels suddenly need to be closed at once. This situation is not unlike the “fire drill” effect that bank runs experience in the real world, when people panic and rush to withdraw their savings from their bank accounts, which triggers a liquidity crisis, which in turn exacerbates people’s panic and creates a vicious cycle until all the money in the bank is taken out and the economy collapses. It is dangerous to put an infinitely scalable (in the txn dimension) system on top of an absolutely finite system that controls the on\off ramps into the system. Furthermore, scaling in this dimension will only help payments. The Lightning Network will not facilitate all other use cases of the Bitcoin blockchain, such as second-layer colored coin overlays using OP_RETURN , or the OP_MULTISIG operation to embed metadata into the Bitcoin blockchain.

Second, the security model in the Lightning Network is the opposite of the one used in Bitcoin. In Bitcoin, you don’t own any money until I send it to you. You can’t do anything about it unless you steal my private key and take the money away. In contrast, in the Lightning Network, the security of the payment channel requires constant monitoring to ensure that your counterparty doesn’t steal your money by publishing old channel states to the network.

This means you either have to have a constant node running software (yet to be developed) that monitors the blockchain for invalid channel states (at which point you will force close the channel and wait the required delay before releasing the funds) or you can pay for the service. This service is provided by new service providers called channel insurance companies or payment centers. If you choose not to use channel insurance, and decide to do this service yourself, you may be vulnerable to overlapping attacks if you are not careful, where a malicious node will try to isolate and hide (or replace) what is actually happening in your blockchain so that you don't notice that it is trying to steal the funds in your channel. Basically, Bitcoin's security model changes to one where you have to actively prevent theft, rather than one where you have passive protection against theft (assuming you manage your own private keys).

Third, Bitcoins in Lightning Network channels cannot be easily spent outside of Lightning Network. While proponents will say that this is not a problem if enough people use Lightning Network so that you can pay everyone in the network. For most of the growth phase of the network this will not be the case and there will be a price premium for Bitcoins that are *not* blocked in Lightning Network channels. This is bad for fungibility of Bitcoins because there will be a separate market for Lightning Bitcoins that are *free*. At least the price difference is the time value of the lock duration that payment channels must wait in case of uncooperative channel closures, which is 2 weeks. If you think about it, this means that Lightning Network is just a pseudo-decentralized bank account. Unlike a bank account in the real world, you don’t need to worry about the bank holding your money declaring bankruptcy, but your money will still be blocked in their system and moving money out of the system can be a hassle. Worse, if everyone allocates too much or too little to create channels, then this will create more on-chain txns needed on top of the Bitcoin layer, which may not be able to handle it.

Fourth, the economics of payment channels and efficient routing between n-to-m endpoints means that the most efficient (in terms of minimizing hops) configuration of the network will be large payment hubs that will allow everyone else to have open channels (and each other). This way, if Alice wants to send money to Ben, the route will be Alice -> [hub 0..n] -> Ben. In the case where Alice and Ben are friends, this will likely be without a hub, but in the case where Ben is a stranger halfway around the world, there could be multiple hubs, with payments processed through them. The system will tend to minimize the number of hubs because it is more efficient, limited only by the amount of free capital (in BTC) that a hub needs to maintain payment channels. This means that whoever has more money will be able to open and maintain more payment channels and become a payment hub. Who has the most free capital? Banks. Existing banks would be the best actors to run payment hubs. The only difference between this and the current system is that you don’t need a license to start a payment hub (aka bank). Although I would be concerned that if enough unregulated payment hubs emerged, governments around the world could make them illegal to operate, resulting in large amounts of Bitcoin leaving the payment hubs and a large number of channel closures. It is this peak of txn flow that Bitcoin cannot sustain if we do not simultaneously scale the network foundation.

Innovation? Or just a new twist on an old conspiracy?

Lightning is absolutely the way to scale Bitcoin txns to VISA levels in the long run. Passing cryptographically signed promises to Bitcoin is a very clever idea, but it was not the original idea. We have a 'lightning' network for over 600 years, called bank accounts, where we basically just move IOUs and promises of value around. The only benefits the Lightning Network brings are cryptographic signatures to prevent theft, and the ability to keep the system decentralized so you don't need a license to operate a Hawaladar. Since the Bitcoin system is often touted as digital gold, it's surprising that many proponents don't admit that any real gold investor would immediately say they've heard of a layer 2 IOU network. This is, of course, exactly the same way that the world's last sound monetary system is being systematically eroded and eliminated. Gold was too expensive to trade, so paper gold certificates were issued to replace it. We all know how that ended.