Lightning

Perhaps the most interesting and promising second layer scaling proposal today is the Lightning Network, which is a new emerging ecosystem of node implementations that allows for an automated, fast, and cheap implementation of a multisig channel-based payment network. Lightning nodes open channels with one another by sending funds to a multisig address using an on-chain transaction. Each party keeps an individual balance on the multisig account, and the parties can pay each other by signing off-chain lightning transactions that reflect their updated respective balances. When either party chooses to close the channel, an on-chain transaction (reflecting the result of all the off-chain balance updates) is sent from the multisig channel address to the two parties with their respective outstanding balances. But Lightning users do not necessarily need to build channels with everyone with whom they wish to transact, as payments can be routed through various other nodes and channels to link two parties who do not share a channel. As the number of channels and the liquidity they contain rise, the possibilities of routing payments between users increases. Individual nodes that route payments between nodes can charge routing fees to compensate them for providing the liquidity.

The strength of this approach to scaling is that the setting up and closing of a channel requires just two on-chain transactions in total, and allows both parties to conduct an effectively infinite number of off-chain transactions. Additionally, the timing of the on-chain transactions is flexible, since channels can be opened and closed when demand for on-chain transactions is low. People who establish a pattern of repeated transactions can settle transactions locally on their channel, or through other channels, without having to record every transaction on the Bitcoin blockchain. Despite these benefits, it is important to remember (as Light ning Network engineers such as Alex Bosworth emphasize) that an off-chain transaction on Lightning is not as secure as an on-chain transaction. While most analysis I have seen suggests Lightning is highly secure, it is beyond the scope of my expertise to compare its security to on-chain transactions. I will focus instead on analysing the liquidity of the Lightning Network and how it affects its operation.

The real limitation of the Lightning Network is not in its security or number of transactions, but the depth of the liquidity pool in the network. More people on the network and more money sent to payment channels produce a higher chance that an individual can conduct a trade with someone else on the network (as well as a higher chance that the payment can clear quickly and with low fees). This pool of liquidity, however, is not something that can be solved naturally as the network grows in popularity. The provision of liquidity to the network is a highly complex web of individual economic decisions inextricably linked to people's valuation of time and the inescapable uncertainty of the future.

In page 250 of Human Action, Ludwig von Mises discusses how uncertainty about the future is the key driver of demand for holding money. With no uncertainty of the future, humans could know all their incomes and expenditures ahead of time and plan them optimally to avoid ever having to hold cash. But as uncertainty is an inevitable part of life, people must continue to hold money for future spending.

Committing a balance of bitcoin to a lightning channel is not the equivalent of holding a cash balance, because the money on that channel is only useful for payment for the counterparty of the channel or others who are connected to them on the Lightning Network, and because establishing channels involves non-negligible costs in fees, time, and coordination. Also, user's channel funds are only liquid to the extent the counterparties in their channel have liquidity. Since liquidity in a channel can generate a return in terms of routing fees, it is more accurate to understand channel balances as an investment to secure routing fees, as well as an option contract: having the right but not the obligation to instantaneously send value through that channel as long as it is open.

Since there is profit to be made from providing liquidity, the optimal liquidity decision for a particular node is not based on individual demand for liquid cash balances, but rather an investment decision based on expected returns from routing fees. If people managed their lightning balances solely based on their need for cash balances, there would be no reason to expect sufficient liquidity to route the payments of others. But since there is a market demand for liquidity, the amount needed to meet that demand will be provided by investment in that liquidity for a return, which implies specialization.

With digital technology, anyone can send a cheap signal to clear a payment and settle it. In reality, the difficult part of payments is the initial deferral of consumption liquidity allows in order to then provide it to those who request it. The job of banks in processing payments can be understood as the provision of liquidity, and in traditional finance they are the ones able to put up cash for payments when needed. As the Lightning Network grows, I believe it will become clear that its growth depends on professional management and provision of liquidity.

The management of the liquidity on channels to optimize for fees is more similar to a specialized commercial enterprise managing liquidity than to individuals managing their expenditure between bank accounts, credit cards, and cash. It is unlikely that an extensive network of liquidity and routing could develop purely from individuals entering into channels with one another, primarily because each individual will be bottle necked by the liquidity held by their channel counter parties. When an individual opens more channels on the network they create more liquidity for it, but they'll also incur higher costs involved in opening and closing channels. In contrast, opening a channel with a single node specialized in providing liquidity (and with an extensive structure of channels open with many other nodes) will allow that person far more liquidity and reach.

The opportunity to profit from providing reliable liquidity and routing to users suggests that if the Lightning Network were to continue its growth, providing liquidity would likely grow into a profitable and highly sophisticated business. Economic efficiency suggests that the network would be far more robust if liquidity were to become a professional service provided by businesses to consumers.

In such a scenario, one would expect a hub-and spoke type of arrangement where a global network of nodes with large liquidity all open channels with one another, while individuals would have just a few channels open with these large liquidity nodes. A robust network of nodes each with large liquidity would allow individuals access to cheap and quick routing through deeper liquidity.

Further, if the analysis above with regard to need for custody is accurate, then it is expected that many people will prefer to avoid having to deal with channels themselves, and instead have their bitcoin held in custody by lightning node operators who can also clear payments on-chain.