Bitcoin and the stream of cryptocurrencies that followed in its wake have entranced investors and startups in recent years. As Bitcoin’s value soared in 2017, and even as it plummeted in 2018, many are convinced that Bitcoin technology is the future of truly decentralized economy. Others doubt this. Their main point of contention: Bitcoin’s scalability. It seems that scalability lies at the heart of the debate about whether or not Bitcoin can replace conventional financial systems.
The most recent solution to this problem is the Lightning Network. First unveiled in a white paper in 2015, the potential of the Lightning Network to enable vast amounts of Bitcoin transactions at low costs came to the forefront at the Blockstack Summit in July 2017. Is the Lightning Network the silver bullet to Bitcoin’s problems?
Bitcoin Technology and Its Scalability Problem
In a layman’s terms, a Bitcoin transaction is basically a message that is posted to the blockchain. The blockchain can be thought of as a ledger that is secured by decentralized computers. Each of these “messages”, regardless of how small, has to be computed and shared with all computers on the network. And that takes some serious computing power. The result: regardless of how secure Bitcoin transactions are, and how alluring the idea of a completely decentralized financial system, Bitcoin can’t rival traditional financial systems.
Bitcoin transactions are too expensive, and processing them takes too long. Bitcoin remains useless for making small, everyday purchases, in other words.
The Lightning Network at a Glance
For a technical overview of the Lightning Network, we recommend the newest version of the white paper (linked above) and this overview published in Cointelegraph. This article will explain the Lightning Network’s functionality only in the most basic terms required to make sense of the question: “is this a possible solution?”
The Lightning Network’s solution to scalability issues is to create two-way, off-chain payment channels for Bitcoin transactions. Between only two people, the Lightning Network roughly works in the following way: two people engage in a funding transaction which is registered on the blockchain as always. The funding transaction is therefore subject to normal waiting times and transaction fees.
However, by leaving the funding transaction open, the parties can insert a commitment transaction which functions like a smart contract. The two parties have now created a “payment channel” between them. Say the funding transaction amounted to a contribution of 1 BTC each. The two parties now have an off-chain payment channel between them with a cap of 2BTC. They can shuffle the 2BTC in between them as payment instantly, off-chain.
The Lightning Network also incorporates a functionality for the “punishment” of a dishonest party: if one party attempts to fraudulently withdraw from the payment channel, the other party has the ability stop that transaction and in effect sanction the other party. Remedies for breach are built into the system, with one important caveat: this only works if the other party regularly checks to see if anything untoward has happened. Some have suggested “watchtowers” that can take over the function of third-party enforcers.
For the Lightning Network to have potential however, the key lies in expanding this mechanism beyond two-way transactions. Parties don’t want to create a payment channel for every single transaction – that saves no costs or time. The solution? Users can route payments through intermediate user’s channels. This means that paying anyone with an open channel should be possible. These multi-channel transactions will likely involve small fees to reward nodes for funding channels and keeping them open.
Is the Lightning Network the Answer?
The potential of the Lightning Network is enormous: if it can realistically lead to large volumes transactions being processed cheaply and quickly, Bitcoin technology has solved its most pressing challenge. However, there is cause for skepticism.
A big challenge associated with the Lightning Network is the fact that payment channels are dependent upon initial funding transactions and therefore have caps. If a transaction is for 0.6 BTC and the payment channel only contains 0.5 BTC, the transaction is impossible. The result is a liquidity trade-off for users.
From an economic perspective, it seems obvious that the success of the Lightning Network will depend on the widespread creation of “hubs”: nodes with lots of capital. This is where the incentive structure inevitably leads.
For many in the Bitcoin movement, who have always said its central benefit is decentralization, this is not attractive. The centralization of well-funded hubs sounds very much like centralized banking in a new disguise.
Although the Lightning Network creates the possibility of scalability, it is not there yet. In May of this year, there were fewer than 1,000 lightning nodes open. Furthermore, the Lightning Network is not the only possible solution to the scalability issue. Bitcoin Cash is a serious contender, for example. (Bitcoin cash is a hard fork of Bitcoin that allows larger blocks). When it comes to the best way of establishing scalability, the jury is still out.
There is an ongoing lively debate about the legal implications of the Lightning Network. It is not at all clear that the network will fly under the radar of legal regulation. On the contrary.
For example: FinCEN’s (the Financial Crimes Enforcement Network) definition of money transmitters seem to include Lightning Network hubs and intermediary nodes. In addition to this, the IRS requires that all third party settlement organizations report transactions. It is very likely that Lightning Network hubs will have to comply with this requirement.
All things considered, it seems unlikely that the Lightning Network solves all of Bitcoin Technology’s problems. At least not today. Who knows what the future may hold?
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