A Look At the Lightning Network
Examining the scaling method of the Bitcoin network and its evolution from a store of value to a medium of exchange.
This article examines the relationship between a monetary asset being a store of value vs. being a medium of exchange.
Specifically, it focuses on the scaling method of the Bitcoin network as its main example. It also takes a broad look at the history of trade-offs in the cryptocurrency space to see why a layered approach makes the most sense.
The primary goal of this article is to examine how Bitcoin has evolved as a medium of exchange and, more broadly, to analyze the order in which new monetary assets can be accepted as a store of value and a medium of exchange.
As a big part of that, I’ll include an analysis of the Lightning network, a small but fast-growing payments layer interwoven into the Bitcoin network.
This article is long, so I’ll summarize the main points up front here, and then spend the rest of the article diving into the details.
A truly decentralized and permissionless payment network requires its own underlying self-custodial digital bearer asset. If instead it runs on top of the fiat currency system or relies on external custodial arrangements at its foundation, then it is neither decentralized nor permissionless.
In order to create a truly new digital bearer asset that is useful for payments in the long run, it must also be an attractive store of value, so that a meaningful percentage of the population begins to persistently hold it as some percentage of their liquid net worth and be willing to accept it for goods and services.
In other words, in order to create a decentralized version of Visa, beneath that you must first create a decentralized version of Fedwire, and along with that you must first create a decentralized version of digital gold. It’s hard to envision any other path succeeding.
Bitcoin started with a smart design from the beginning. It created an underlying digital gold and settlement network, with a credible degree of decentralization, auditability, scarcity, and immutability that no other network currently rivals. On top of that foundation, Lightning as a payment network is being developed, and has reached a critical mass of liquidity and usability.
Many cryptocurrencies that followed in Bitcoin’s wake put the cart before the horse. They optimized for throughput and speed on their base layer, at the cost of weaker decentralization, auditability, scarcity, and/or immutability of the underlying bearer asset. As such, they failed to gain structural adoption as money and rendered their high throughput irrelevant, especially since they were brought into exist in the shadow of Bitcoin’s larger network effect.
Volatility is inevitable along the path of monetization. A new money cannot go from zero to trillions without upward volatility by definition, and with upward volatility comes speculators, leverage, and periods of downward volatility. The first couple decades of monetization for the network as it undergoes open price discovery to reach the bulk of its total addressable market, should be different than the “steady state” of the network after it reaches the bulk of its total addressable market, assuming it is successful in doing so.
Taxes on cryptocurrency transactions, as well as the lower supply inflation rate of bitcoins compared to fiat currencies, results in Gresham’s law being applicable here. Most people in developed countries have an incentive to spend their fiat and hoard their bitcoin like an investment, at least in this stage of the monetization process. The exception is for the subset of people who specifically need Bitcoin/Lightning’s permissionless nature for one reason or another, or for whom the majority of their liquid net worth is in it.
People in developing countries, with higher inflation and weaker payment and banking systems in general, have more of a natural incentive to use Lightning as a medium of exchange earlier on its monetization process. Indeed, adoption rates are rather promising in many of those regions. This isn’t surprising, considering that more people in developing countries have smart phones than bank accounts, in aggregate.
An overview of how the Lightning network works in a basic sense, and why channel-based transaction systems make more sense than broadcast transaction systems for individual payments.
A look at other use-cases for the Lightning network, including its usage as a fast settlement system to move dollars and other fiat currencies around globally, through the core bitcoin liquidity of the network.
A response to various criticisms of the Lightning network, including an explanation of why comparing its small size to various larger DeFi projects is a category error, and an analysis of its scaling potential.
Concluding thoughts on the regulatory and enforcement hurdles governments face now that open-source peer-to-peer payments technology exists.
Humans in tiny groups don’t need money; they can organize resources among themselves manually.
However, groups that reach the Dunbar number or larger usually start identifying and using some form of money, which gives them a more liquid, divisible, friction-minimized, and widely-accepted accounting unit for storing and exchanging value with people they don’t know.
What makes good money?
And how does new money get adopted by users?
I cataloged the history of this question from multiple points of view in my article, "What is Money, Anyway?"
The short answer from thousands of years of history across multiple continents is that commodity money that is adopted organically needs to have a reasonably high stock-to-flow ratio and needs sufficient divisibility, portability, durability, fungibility, and verifiability while being desirable to hold for some reason.
When different commodity monies come in contact with each other, often due to contact between cultures with varying levels of technology, the money that is harder to produce (i.e., able to maintain a persistently higher stock-to-flow ratio even in the face of improving human technology) wins out. Money in a society generally consolidates towards one or two, rather than many of them coexisting indefinitely. Precious metals, specifically gold, won the commodity money competition over thousands of years.
Ledger-only systems, referring to paper and bank currency systems with flexible money supplies that are backed by nothing and have no cost to produce, have been tried several times in history. Each of those fiat currencies inevitably failed over a long enough timeline. The temptation by central policymakers to produce more, especially in times of crisis, is always there. To assume that such a system can last forever without a breakdown or reset of some sort is to assume that there will be an unbroken chain of competent and selfless centralized operators of that monetary system.
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However, with the development of telecommunications technology and global bank ledgers, fiat currencies eventually offered an actual improvement in long-range transaction and verification speeds compared to precious metals, which along with the taxation or sometimes outright banning of precious metals and other monies, is part of what lead to their widespread adoption for the first time in history.
Precious metals as bearer assets were not divisible or portable enough to keep up with global commerce at the speed of telecommunications channels. They thus had to be abstracted with pegs, claims, and counterparty risk. Due to this speed mismatch and subsequent abstraction, policymakers dropped precious metals away from the process altogether, other than keeping them as opaque sovereign reserves. They created a ledger-only system around the world that is currently in its sixth decade of operation.
The dollar has a lower stock-to-flow ratio than gold but does have a higher average stock-to-flow ratio than most other commodities and has the property that it can be sent around the world relatively quickly, while most of its scarcer competition (e.g., gold) is both slow and taxed. The dollar is not something you particularly want to store value in for decades. Still, it clearly has its use cases in terms of payments and near-term savings due to how the global financial system has been engineered.
I do, however, think that this fiat system that has been in place since the 1970s is becoming more unstable and will end up undergoing longer-run devaluation and realignment to clear excess debt out of the system. That process has already been in place for over a decade in the U.S., and I expect it to continue both here and elsewhere in the world:
And when we look globally, there are dozens of countries with current or recent inflation rates over 25% and/or that have had currency resets or hyperinflations within our lifetimes.
The Bitcoin network introduces faster payment and settlement speeds than fiat currencies. Still, its units also have a higher stock-to-flow ratio than gold. They can be used as self-custodial and peer-to-peer through the decentralized network.
However, it’s new and volatile, poorly understood, and certainly not without risk, so bitcoins often get criticized for being too volatile to be used as a medium of exchange. And outside of niche circumstances, bitcoins are only lightly used as a medium of exchange in their current early stage of monetization.
Several cryptocurrencies market themselves as faster competitors to the Bitcoin network and thus better-suited as a medium of exchange. Putting aside smart contract platforms and proof-of-stake coins for the moment, we can do a cursory look through some of the notable proof-of-work monies that have sprung up in the wake of the Bitcoin network.
It’s natural for the market to explore multiple wrong answers to see in practice what the right answers are. Part of what allows me to analyze these concepts is the historical track record of why and how various projects failed to accrue value.
Litecoin was invented in 2011 based on the design of Bitcoin but with a few changes regarding how it is mined and how long its block times are, and marketed as “silver to Bitcoin’s gold.” Specifically, it uses faster 2.5-minute block times compared to Bitcoin’s 10-minute block times. It hit big highs in 2013 and then hit much bigger highs in 2017, at which point the creator sold his position at the top of the market. In 2021 during the altcoin season, Litecoin roughly matched those 2017 highs but wasn’t able to gain traction to go up multiples from those highs. After a long stretch of being in the top ten coins by market capitalization, it’s starting to stagnate and fall down the market cap rankings of cryptocurrencies and is no longer in the top ten.
As one of the oldest coins that continue to operate as designed, Litecoin’s price chart, denominated in Bitcoin, is a quintessential example of how most coins persistently degrade over time in Bitcoin-denominated terms after experiencing their initial price spike:
Dogecoin, created as a joke in 2013 based on the design of Litecoin, managed to hit notably higher highs in 2017 and then had a massive meme spike in 2021 thanks to pumping by Elon Musk, followed by a 90%+ crash. It has 1 minute block times and no supply cap. Numerous other dog-themed meme coins have come along in its wake, each having a brief spike before crashing. These joke coins tricked many retail investors into buying them at the top. Unfortunately, Several crypto exchanges marketed them aggressively to retail investors right at the top to make a quick buck. They, therefore, contributed to a bubble that sucked a lot of people in for major capital losses.
Monero, created in 2014 as a privacy-themed coin, has yet to decisively surpass its 2017 highs and has fallen very deep in the cryptocurrency market capitalization rankings. Monero uses some interesting privacy mechanisms but relies on indirect proofs to audit the supply, which means there’s a nonzero chance of an undetected inflation bug at any given time. Monero has 2-minute block times, and the way it is designed does not currently allow for a Lightning-like payment channel network to exist on top of it. I would like to see more privacy development within the Bitcoin ecosystem to make privacy techniques more automatic and easier to use.
Bitcoin’s hard forks, like Bitcoin Cash “BCH” and Bitcoin Satoshi Vision “BSV” have fared worse. Some went away, while others, such as these two, survived in a weakened state. They have in common that they increase block sizes so that more transactions can be packaged into each block. Both of them have gone down significantly in bitcoin-denominated terms. Bitcoin Cash, which was forked from the primary Bitcoin network in 2017, has yet to be able to touch its 2017 highs in dollar terms. Bitcoin Satoshi Vision forked from Bitcoin Cash in 2018, has been in a choppy sideways pattern since inception, is below the price it split at, and has been the subject of 51% attacks due to its low hash rate. If about 1% of Bitcoin miners want to make a 51% attack on either of these chains, they can do so since Bitcoin’s hash rate is orders of magnitude higher, and they all share the same hashing algorithm.
The main problem with having faster block times and/or larger block sizes is that if the network is heavily used, the bandwidth and storage requirements for running a full node become rather high, which makes it hard for the typical user to run a full node to audit the network. By extension, that makes the network rules less credible and immutable since the number of full nodes is tiny. Going too fast can also create problems with stability.
When we look at the adoption pattern of the Bitcoin network and some of its failed forks and competitors, we can quickly see a basic problem that many of these forks/competitors encountered and why they failed. They tried to make a broad medium of exchange out of something that was not a store of value and without the government’s power of fiat. And this was in addition to the fact that they had the big problem of existing in the shadow of Bitcoin’s far more dominant network effect.
They even went to sacrifice their decentralization, immutability, and audibility (a big piece of what could potentially make something like bitcoins a store of value) to advance their goal of being a medium of exchange. This path, however, leads to failure and irrelevance.
In other words, to invent a successful decentralized peer-to-peer Visa-type network (fast transaction layer), one must first invent an underlying decentralized peer-to-peer Fedwire-type network (settlement layer), along with a reason why the underlying unit should be held for the long-term compared to other assets (digital gold).
The fascinating thing about watching the Cambrian explosion of new private monies or “cryptocurrencies” since 2009, based on Satoshi Nakamoto’s creation of the Bitcoin network, is that it represents a new test for economic theories on what makes good money vs. what does not.
Everybody has a theory on what makes some monies better than others, but the market decides in the long arc of time. Even for government-controlled currencies, the international market decides between them. Any cryptocurrency can have success in the intermediate term. Still, the real test is which ones, if any, can stick around and gain structural adoption over many years and decades through bull and bear markets alike.
So far, the Bitcoin network has gotten through four huge bull/bear cycles (2011, 2013, 2017, 2021 bull cycles) while gaining value and users in an exponentially compounding way. Each bull cycle reached a scale significantly larger than the prior bull cycle in terms of market capitalization and the number of users.
Now, it is legal tender in a few regions of the world, and several large institutions hold it on their balance sheets in various ways.
Simple “bubbles” don’t survive through several 70%+ drawdowns over a period lasting thirteen years and counting; it looks more like Metcalfe’s Law of network adoption at this point. That doesn’t mean it is without risks. Still, it should be studied and understood rather than dismissed to see what it is about this network that allows it to keep growing through resistance.
And most notably, bitcoin did this without any central organization promoting it. The inventor disappeared by 2011, and then even his follow-up lead developer and several other early developers left in the ensuing years due to various technical disputes involving the block size. It has been a rather decentralized, open-source, self-sustaining network of rolling participation ever.
Out of the other thousands of cryptocurrencies, the vast majority fail to successfully get through one cycle. They have a big bubble spike during a bull market, then crash, and never recover those bubble highs again. Founders, insiders, and others who bought super early can have spectacular gains on the back of the investors who came in late. Still, their coins don’t lead to structural adoption and growth. Only a small handful of them have made it through two or three cycles of higher dollar-denominated network value.
For the Bitcoin network, usage as a niche censorship-resistant medium of exchange came first, followed by its being used as a broader store of value, which became a much larger use case. From there, the more it is used as a store of value and the better its scaling solutions become, the more it can be widely used as a mass medium of exchange.
Let’s consider adoption patterns. Suppose you owned some bitcoins and other cryptos sometime in the 2011-2017 range when all of those various blockchain monies and forks were in the heat of their competition against the Bitcoin network as a medium of exchange and being marketed as such.
Before the launch of the Lightning network, if you were a person with easy access to banking and payment services and were not de-platformed from anything in particular, why would you spend Bitcoins on anything?
If the number of dollars keeps increasing yearly, but Bitcoins have a hard supply cap of 21 million coins, why would you want to give your Bitcoins to others?
Unless you’ve been holding Bitcoin so long that it has become a meaningful share of your net worth, or you actively work in the industry and potentially even get paid in Bitcoin, you probably wouldn’t.
This problem is then magnified by the fact that Bitcoins have ten-minute average confirmation times, Bitcoin cash coins have ten-minute average confirmation times, and even Litecoins and Dogecoins, which are meant to be faster, have 2.5-minute and 1 minute average confirmation times, respectively, which is still too slow for convenient in-person transactions. The process is longer if you want to wait for several confirmation times to reduce the probability that the transaction will be reversed. These are crappy things to buy coffee in that form. It’s like trying to buy coffee with a wire transfer. No thanks. That’s what Mastercard is for.
There are circumstances where the Bitcoin network’s base layer payment options are ideal as a medium of exchange, but to try to force it in a situation where it could be better, doesn’t make sense. As I described in my "What is Money, Anyway?" article, Bitcoin base layer payments are tank-like censorship-resistant. Owning Bitcoin represents the stored-up ability to make censorship-resistant global payments in the future and/or to portably bring wealth worldwide, even by just memorizing twelve words or holding a private key somewhere on your physical person or in your digital files.
This transaction problem is further compounded by the fact that every cryptocurrency transaction is a taxable event. Governments don’t want other monies to compete with theirs if they can help it, so they view your Bitcoins as commodities, and if you exchange them for something, you’ve now locked in a taxable capital gain. Assuming you don’t want to break tax laws, you need to keep track of every bitcoin/crypto transaction you do for tax season.
Furthermore, the number of people with any meaningful amount of their net worth in Bitcoin or other coins still needs to be higher. What is the immediate incentive for a merchant to accept Bitcoin or other coins unless they serve a niche industry where the percentage of Bitcoin or crypto users in their customer base is higher than normal?
I’ve described this merchant acceptance problem in prior research pieces when discussing the credit card oligopoly. Four meaningful card networks in the U.S. extend globally: Visa, Mastercard, American Express, and Discover. These have been around for decades. Merchants accept them as payment because that’s what all of their customers have in their wallets. Customers have them in their wallets because merchants widely accept them. These networks' flywheels were bootstrapped decades ago.
Creating a fifth credit card in the U.S. would be nearly impossible. You’d have to convince merchants to accept it despite users not yet having it, and you’d have to convince users to get one even though merchants don’t accept it yet. It’s hard to bootstrap from nothing and compete with existing network effects.
Bitcoins and various cryptocurrencies encountered the same problem. Some places accepted them as a novelty, and some people wanted to spend them here or there, but for the most part, the topic of cryptocurrencies as everyday payments was a dud during that whole 2011-2017 era, just like trying to launch a fifth credit card would be, except slower and more taxable.
The primary users of Bitcoin for the medium of exchange purposes in those early years were people who were de-platformed in various ways. Cypherpunks were naturally attracted to Bitcoin’s censorship-resistant payments. Wikileaks turned to accepting bitcoins when they were de-platformed from PayPal in 2010. A subset of early users bought drugs on the internet with bitcoins until those centralized marketplaces were shut down. Human rights advocates began using Bitcoin in authoritarian regimes with low banking access or vulnerability to arbitrary bank freezes. These use cases weren’t for efficiency but for peer-to-peer censorship resistance.
For mass medium of exchange usage, meaning far beyond niche censorship-resistant use cases, new money likely needs to become a store of value first if it is to arise organically rather than through government decree. And the payment experience needs to compete with various near-instant fiat payment methods. Many people need to have a lot of money and start asking merchants, “Why don’t you accept this yet?”
As it gets big enough or becomes perceived as offering better payment solutions than legacy systems, several jurisdictions can even remove the per-transaction tax on it.
Since store-of-value usage precedes mass medium of exchange usage, the fatal flaw of Litecoin, Dogecoin, Bitcoin Cash, Bitcoin Satoshi Vision, and most of these types of attempts at medium of exchange cryptocurrencies is that they put the cart before the horse.
As previously described, these types of projects wanted to sacrifice some degree of stability, decentralization, immutability, or auditability to optimize themselves as a higher-throughput medium of exchange, even though only some people were using them as a store of value yet, with negligible adoption. They were just building fintech payments companies with tiny teams of people and expecting to compete with Visa, despite having a worse user experience, slower speeds, and way less transaction throughput.
And yet, if we steelman their position, it’s somewhat understandable why some of them tried to do that: Satoshi Nakamoto described his original design as a peer-to-peer e-cash system, and what exactly “cash” is can have a few different meanings. In 2010, Satoshi briefly wrote about how the network could gradually scale in terms of block size over time, even though he also put the block size limit into the code. After he left, however, some people wanted to scale too much and too early without broad consensus to do such a contentious hard fork. By jamming hard forks through and going in their own direction away from the Bitcoin network, users of these other protocols had to go through the difficult experience of seeing how powerful the widely-distributed network of node users had become and how pushing unwanted updates to them is impossible.
I think too many people in those early years interpreted “e-cash” to mean quick-and-easy payments for everyday goods using the base layer when a better way to think of cash today is as a private censorship-resistant final settlement transaction method. Physical cash, after all, is not necessarily the easiest payment type or a medium of exchange that we need to use for everything, but it’s the most private and the hardest to prevent from occurring.
Therefore, when we think of “e-cash,” we likely shouldn’t think of it as optimizing for speed and efficiency right on the base layer for every transaction that we do, but rather we should think of it as optimizing for those same things that physical cash is great for private and censorship-resistant final settlement payments that can be used when it makes sense to do so.
Plus, bitcoin was already well-optimized for early adopters who wanted to use it as a private medium of exchange online at the time. Some of them viewed privacy as a fundamental human right. They were aware of oppressive regimes where this type of technology could be useful to protect people. Others were dealing with real-world constraints of other means of payment, such as Roya Mahboob, who used it to pay women and girls in Afghanistan, where female bank account access is more restricted. Bitcoin was also used very early by people using online black markets, in a similar way that criminals were early adopters of pagers as a technology (which doesn’t make the technology itself bad).
There were various niches of people where Bitcoin was an ideal medium of exchange from the beginning, and Bitcoin scaled well enough for those niches. Satoshi picked his variables very carefully to ensure that cypherpunks like him had a working anonymous censorship-resistant peer-to-peer medium of online exchange. So, it was and still is a very useful e-cash.
These types of people could and would wait 30 minutes for an online transaction to process with a few confirmations. They could and would run their own node. They could and would use private techniques to acquire and dispose of their coins. This was a utility network with a mild monetary premium. It offered money that a relatively small group of people at the time would desire to use and was recognized for its value by users and speculators. Like almost every commodity adopted as money, it had utility first. It gained a monetary premium second as a result of that utility. The utility was that it provided access to a tank-like medium of exchange network that could exchange value globally without centralized intermediaries to stop it and with a better combination of monetary immutability, censorship-resistance, and liquidity than the countless imitators that followed in its wake.
After enough time had passed, this fluctuating monetary premium of bitcoin’s price attracted speculators and investors that had no intention of using it for a medium of exchange any time soon, similar to why many people buy gold. A subset of Austrian economists, for example, began recognizing bitcoins as being interesting monetary goods; specifically, the finitude of the coin supply at 21 million stood out to some of them. When it became more broadly understood how immutable the Bitcoin network’s ruleset was and how its security, liquidity, and decentralization dwarfed any other proof-of-work cryptocurrencies, many people began considering it hard money. Several human rights activists began to recognize it as an ideal anti-authoritarian technology for its censorship-resistant aspects and use it as such.
The mistake of the Litecoin bulls and the Bitcoin Cash bulls and so forth was that they wanted to scale too early to a bigger group of people before there was a market for it, and even at the cost of weaker decentralization. Bitcoin’s base layer is enough for tens of millions of people to use it occasionally when its specific properties are ideal.
The Bitcoin network on the base layer is like the 60-ton armored tank of payment and savings systems: holding and transferring value globally in a censorship-resistant manner. A tank is ideal if you need to get from point A to point B through hostile terrain and blast through anything in your path. It’s not ideal for commuting to work. Trying to force base-layer Bitcoin transactions to be used as a daily of medium of exchange by the general public is like trying to make commuting in tanks catch on. It’s not going to because that’s not what it’s designed for. And to try to make it scale to everyone for all payments on that base layer makes it lose most of the properties that make it useful for what it does best. It would take over a terabyte of data storage per day to create a base layer system capable of supporting tens of thousands of transactions per second.
The earliest analysis of the Bitcoin network, by Hal Finney and others, predicted that the network would likely evolve towards a layered approach.
There are over 100 million people in the world who are estimated to own Bitcoin as of this past year. That’s 1-2% of the global population, depending on the exact number since the number is reliant on exchange data, surveys, and other opaque assessments. In some countries, however, the adoption percentage is in the low double digits.
However, most of that is pretty shallow. We can quantify adoption by both breadth and depth. Breadth would refer to how many people have a nonzero amount of Bitcoin. Depth refers to how much of their liquid money they have in Bitcoin.
What I mean by this, for example, is that someone having $264.34 USD worth of bitcoin sitting in a semi-dormant crypto exchange account is not “adopting” bitcoin to any economically significant degree.
As a thought experiment, imagine a world where people hold bitcoins and/or dollars as liquid money.
And furthermore, let’s assume (bear with me) that bitcoin continues to increase in dollar price over the long run, albeit with plenty of volatility along the way, as a result of bitcoin’s much lower rate of new unit creation compared to the rate of new dollar creation, and more people learning about Bitcoin and wanting to hold a nonzero amount of it. If someone buys a bit of Bitcoin, even without further purchases, it will become a somewhat bigger share of their liquid money over many years if this thesis is correct.
Now, only 1% of people own Bitcoin, and 99% do not. And suppose that those that own Bitcoin have just 3% of their liquid money in it on average. Total Bitcoin adoption is, therefore, 0.03% compared to 99.97% cash in that system. Bitcoin adoption in that context is negligible. There’s little reason for merchants to accept it other than out of novelty or if they specifically cater to cypherpunks.
If 10% of people own Bitcoin and have an average of 5% of their liquid money in it, then that is 0.5% total adoption compared to 99.5% cash. Still a rounding error, but nonetheless a niche market with millions of people.
If 30% of people own Bitcoin and have 10% of their liquid money in it, then that is 3% total adoption compared to 97% cash. That’s a vocal minority, representing a lot of niche purchasing power.
If 50% of people own Bitcoin and have 20% of their liquid money in it, then that is 10% of total adoption compared to 90% cash. That is a huge market.
If 70% of people own Bitcoin and have 30% of their liquid money in it, then that is 21% of total adoption compared to 79% cash. That’s enormous.
For many people to want to spend Bitcoin, it’s more likely that they would have bought some long ago and perhaps kept buying, took the time to learn how to custody it themselves rather than hold it on an exchange, and after years of price appreciation it’s a decent chunk of their liquid monetary value. They either want to sell some for cash to buy something, or even easier, just buy something with it directly.
Of course, in reality, it is bumpier than that. Some early adopters in this scenario will reach very high levels of net worth in Bitcoin, and they become a wealthy cohort to cater to by niche merchants early on. So mass merchant adoption might take a while, but of course, there would be early merchants that want to cater to that early group or that sell products that many Bitcoin holders would specifically want to buy.
If the numbers in the example above seem extreme (“How could Bitcoin possibly reach a 20%+ share of the dollar market?”), then re-run them for a developing country instead.
Replace the US with Nigeria, and the dollar with the Naira, in the above example. Nigeria has among the highest Bitcoin adoption levels in the world, even though their government has cut off the fiat bank onramps to Bitcoin/crypto exchanges to protect the Naira.
When a currency looks like this, people can and will try to find others to use, even through resistance:
Developing countries with higher average inflation and weaker payment systems are where bitcoins, via the Lightning network, can scale quickly as a medium of exchange. Because for many of them, it could indeed solve an everyday payments problem pretty early on in its monetization process.
That’s why there is often a huge mismatch in perceptions about Bitcoin between privileged commentators and actual users.
To the extent that the Bitcoin network continues monetizing and growing, it’s not because it eats the U.S. dollar or the Swiss franc first. It’s eating periphery currencies with high inflation, weak property rights, and/or bad payment systems first, and then it moves inward from there. Bitcoin is already bigger than the broad money supply of any developing countries and is accepted at more points around the world than many developing country currencies (generally only accepted within their issuing country or at a small number of specific exchange points internationally). Bitcoin merchant acceptance doesn’t have the density of any specific currency within that currency’s issuing country, but it has a wider international reach than most currencies.
The bigger the Bitcoin network gets, and over a longer period, the more rational it becomes for merchants to accept it. The more merchants that accept it, the stronger the network becomes because then Bitcoins don’t need to be converted back into fiat currency on one of a handful of centralized bank-connected exchanges for people who want to use them. In this sense, wide merchant acceptance is a form of censorship resistance. When thinking about this, think of merchants in developing countries more-so than just merchants in developed countries.
And over time, several companies have been created that allow a merchant to easily accept it and then either hold the Bitcoins or exchange them for fiat currency immediately so they don’t deal with the Bitcoins directly. The technical friction for accepting bitcoins as payment keeps decreasing.
Gresham’s law is the principle that “Bad money drives out good.”
If people have a good money and a bad money, they would rather spend the bad money and keep the good money. Ironically, the bad money tends to circulate with high velocity while the good money is hoarded with low velocity.
This trend revealed itself multiple times under bimetallic standards. When gold and silver were fixed relative to each other by government decree, but this “fix” was slightly off the global supply/demand ratio balance, which could change over time. One of the metals would start to disappear from circulation.
There are a couple processes for how that happens.
The first process is simply that the better (undervalued) money gets hoarded, so it stays in the country but gets removed from everyday circulation. People will not usually part with what they perceive as being undervalued.
The second process is that international entities can observe this and arbitrage it. For example, if the global ratio of gold to silver is 15.5 to 1, Americans have it fixed by government decree at 15 to 1 (slightly undervaluing gold vs. silver). A European entity can keep selling silver to the Americans and buying gold from the Americans. As years or decades pass, there will be a lot less gold in the United States and a significant amount of silver instead.
The U.S. broad money supply has grown at more than a 7% annualized rate since 1970. Most developed countries have a similar rate to that, and emerging markets tend to have a much higher rate on average.
Meanwhile, the Bitcoin supply is growing at less than 1.8% per year, which will fall to below 0.9% in a couple years and to around 0.4% four years after that. The Bitcoin network is programmed to asymptotically approach 21 million Bitcoins in total by halving its supply inflation rate every four years until it has 0% supply inflation. And unlike most other blockchain monies, the wide node network helps ensure that no centralizing force can change this distribution pattern. It has the dominant network effect among proof-of-work blockchain monies, which makes it more protected against 51% censorship or transaction-reversal attacks.
It’s natural for people to want to hoard something like gold or Bitcoin and spend their dollars, pounds, yen, euros, yuan, pesos, naira, and rupees. Money that depreciates in value tends to circulate. In contrast, scarce money that tends to appreciate in value gets hoarded with much lower spending velocity.
This becomes especially true if a jurisdiction treats the harder money like property and taxes each transaction, which most jurisdictions do. If you try to use things like gold or Bitcoins as medium of exchange, each transaction is a taxable event compared to your initial cost basis when you originally bought that asset. The incentive, therefore, is to hoard the taxable gold or the taxable bitcoin, with their lower levels of supply inflation, and spend the non-taxable fiat currency on consumption, unless someone strongly desires Bitcoin’s censorship-resistant payments properties.
For example, bitcoins have been used as a medium of exchange by girls in Afghanistan, by Russian political opposition when their bank accounts get frozen, by Nigerian merchants and protesters, by people getting capital out of China, by people getting their money out of Venezuela, Iran, Palestine, and elsewhere, by under-banked people in El Salvador, and more. It’s also used in developed markets for natively-online services, such as Substack or buying VPNs, and many others. And yes, in the early years, people bought drugs online and occasionally for things like ransomware attacks.
I’ve met a number of these human rights advocates in person. One of the most powerful moments was hearing Ire Aderinokun, co-founder of Nigeria’s Feminist Coalition, speak in Norway’s parliament building earlier this year about how when they protested police violence in Nigeria, they had their bank accounts frozen and resorted to using bitcoins instead, for their self-custodial and censorship-resistant properties. I was familiar with that story from the news, but it’s always more interesting and clear to hear first-hand accounts of it from them in person.
In this sense, although Gresham’s Law initially applied to fixed exchange rates, it applies more broadly any time there is transactional friction of some sort, including a tax. The weaker, lower-friction currency will be spent first unless there is a strong practical reason to do otherwise, meaning a use-case that specifically needs Bitcoin’s unique properties.
So, a self-custodied store of value and payment system like the Bitcoin network is great for many people, but its exact usage pattern depends on context. It’ll tend to be adopted as a medium of exchange by people who need it a lot more quickly than people who don’t really need it.
An asset cannot monetize without volatility. By definition, an asset can’t go from being worth zero to having a market capitalization of a million dollars, to a billion dollars, to a trillion dollars, to several trillions of dollars, without upward volatility. That upward price move due to user adoption is volatile.
With that being the case, any upward volatility of this magnitude will attract speculators, leverage, and surges of demand. These speculators eventually get caught up and forced to sell for one reason or another, resulting in periods of sharp downward volatility.
When Bitcoin was held by 0.001% of people, it was extremely volatile and risky since the future was very unknowable, and a few individuals could massively affect the price with buy/sell decisions. When it became held by 0.1% of people, its volatility and risk decreased somewhat but remained high. Now that it’s likely owned in some way by over 1% of people, the risk and volatility keep reducing over time. However, they still are both at a significant level. If it gets to a stage where it is held by 10% or more people, then the volatility and risk would be further reduced.
So, early adopters mainly buy it because they analyze the qualities and consider it a useful network to access. They’re willing to accept the volatility for the long-run potential upside and self-custodial peer-to-peer access it provides. As more people come in, the asset becomes increasingly monetized.
Some ask, “What happens once the network runs out of new buyers?
Doesn’t that make it a Ponzi scheme?”
I addressed the Ponzi scheme comparison in this article and showed why it didn’t fit the characteristics of one. But more broadly, one must ask, “At what point would someone want to permanently exchange their self-custodial scarce money (Bitcoin) that has a 1.8% annual supply inflation rate that is exponentially shrinking for a soft money (fiat currency) that typically has a 7% annual supply inflation rate or higher?”
For many people, the answer is never, as long as the Bitcoin network is still working.
Instead, they want to hold and accumulate bitcoins until enough merchants accept them. At this point, they could spend some of them, especially if there is enough critical mass for them to become legal tender in more jurisdictions by that point. To the extent that they earn more income in the future, they’d prefer to continue to save at least some of that income in something with a fixed supply rather than other things like fiat currency that have an unlimited supply and are growing by new supply far more quickly.
In other words, if successful, the network becomes a self-sustaining global economy of people wanting to save in it, spend it, earn more of it, save more of it, and then spend it. Like, well… Money.
That’s why this meme has been one of the longest-running ones in the ecosystem:
When understood that way, risk analysis regarding the Bitcoin network should focus on questions like, “What events could potentially derail its monetization process?
What events could make the majority of users want or need to sell their Bitcoin, stop viewing it as good long-term savings, and instead hold something else?
What threats could censor the network, disable it, or otherwise disrupt its ability to serve as a tank-like medium of exchange and self-custodial portable savings?”
Those are the right questions to ask, in my view.
With the invention of Bitcoin, Satoshi Nakamoto put together several existing technologies and added some of his own touches to make a rather profound innovation.
For one, the network serves as a decentralized transfer agent and registrar. Proof-of-work miners process transactions (without relying on circular logic like proof-of-stake systems), and the network of nodes enforce the network rules. The result of this is the ability to quickly and globally transfer value without the permission of any centralized third party, as long as no individual entity or coordinating group of entities can persistently control the majority of mining capacity on the network and use that majority to censor it.
Secondly, due to the large number of validating nodes run by individual users, the network offers a credibly immutable set of 21 million units (each divisible into 100 million sub-units commonly referred to as “sats”) because there is no central authority that can change the number of coins on the network. Unlike most forms of software, updates cannot be “pushed” to users by developers; they can only be accepted voluntarily. The result of this is a rather interesting (albeit currently volatile) type of money.
It’s often said that a blockchain is basically just an inefficient database. Users, in this sense, are willing to accept inefficiency to ensure decentralization. They have to broadcast every change to the network and keep track of broadcasts from elsewhere in the network.
A blockchain, especially the truly decentralized variety, is a database that is small and tight enough that thousands of entities around the world can store it on their local devices and constantly update it peer-to-peer using an established set of rules. Each node provides validation to ensure that a new block is following the rules of the protocol, and they will only accept and propagate a new block to other nodes if the new block follows the rules. A large number of user-run nodes helps ensure that the ruleset is immutable. In contrast, if there are only a handful of nodes, it only takes a small quorum of people to rewrite the network rules.
Plus, the easier a node runs, the more auditable the network is for a regular user. More specifically, nodes simply give each user financial self-sovereignty to privately verify their transactions rather than rely on any trusted third party.
A fully-centralized database has fewer limitations because it doesn’t need to be small and tight. A large service provider can have an utterly massive database in a server farm. That can make things run very efficiently, but unlike with a blockchain, outside entities can’t directly audit it for content and changes and have no way to stop the owners of that centralized database from doing whatever they want with it.
So, every blockchain network that claims to improve something compared to the Bitcoin network on its base layer makes multiple trade-offs to do so.
To increase the number of transactions that can occur over a span of time on the base layer, either the block size or the block speed needs to be increased. However, this increases the bandwidth and storage requirements of running a node and often puts it out of the reach of a normal person. And in particular, if the requirements to run a node grow faster than the rate of technological growth in terms of bandwidth and storage, it leads to a shrinking node-set over time, which centralizes the network. Trying to scale the network to perform as many transactions as Visa just turns the network into Visa, a centralized entity.
To increase privacy, some degree of auditability needs to be sacrificed. One of the key things about the Bitcoin network is that any node can tell you the exact Bitcoin supply and has the entire history of transactions and the full state of the ledger. That’s not possible to the same degree in a privacy-based system. In addition, if a privacy-based system doesn’t have a serious network effect, privacy is not necessarily as perfect as advertised because the anonymity set is very small and is, therefore, somewhat trackable. Privacy is largely a function of liquidity, and if liquidity is lacking in various privacy-focused ecosystems, then their privacy potential is limited.
To increase code expressivity (e.g., executing complex smart contracts right on the base layer), a network must also increase the bandwidth and storage requirements of full nodes, making running a full node harder and thus centralizing the network over time, as previously described. In addition, it increases the complexity and number of possible attack surfaces. Lastly, it makes the network a means to an end rather than an end in and of itself, which means that many users will go towards whatever smart contract blockchains are cheapest.
Replacing proof-of-work with proof-of-stake requires accepting a circular validation process. In a proof-of-stake system, the coin holders are determined by the state of the ledger and the state of the ledger is determined by the coin holders, a perpetual motion machine based on circular logic, which doesn’t have high fault tolerance. It is nearly costless to make infinite copies of the blockchain with different transaction histories. If the network goes offline, there is no way other than governance decisions and centralized checkpoints to determine which ledger is the “real” one. It would be like a corporation serving as its own transfer agent and registrar for its shares, which is inherently circular. A proof-of-work system uses energy as that external arbiter of truth, which makes it non-circular and a true timechain rather than merely a blockchain.
Bitcoin has been largely successful due to its widely-distributed node network and the concept of “monetary self-sovereignty.” Anyone with an old laptop or Raspberry Pi and a basic internet connection can run a node and verify the whole system from Genesis. Decades from now, that will still be the case. The requirements to run a node increase more slowly than the technological increases in bandwidth and storage, which means that a node gets easier and more accessible to run over time. As a result, Bitcoin is inherently designed to get more decentralized over time, in contrast to most other cryptocurrencies that inherently get more centralized over time.
If developers want to change something about the Bitcoin network, their changes cannot be forced onto users' nodes. The ruleset of Bitcoin is determined by the network of existing nodes. In practice, any changes to the Bitcoin network must be backward-compatible upgrades, which node-users can voluntarily upgrade into over time if they want to while still being compatible with older nodes. Any attempted upgrades that are not backward compatible with the existing node network are merely hard forks- they create separate new coins like Bitcoin Cash that lack a network effect and lack serious security.
Trying to do a hard fork from the Bitcoin network is like copying all of the data from Wikipedia (it’s actually not that much) and hosting it on your own website, and then getting very little traffic because you don’t have the millions of backlinks that point to the real Wikipedia, or the volunteer army of people that constantly update the real Wikipedia. Your split version of Wikipedia would be inherently worse than the real one from the moment you copy it.
If nodes had much more requirements to run, then only large entities could run a node, and the set of nodes would be much smaller. A consortium of miners, exchanges, custodians, and other large entities could agree to make changes to the network. And if that’s the case, then immutability and decentralization are lost for the network. In particular, the 21 million finite supply could be changed, and the censorship-resistant properties would be threatened.
What gives Bitcoin its “hardness” as money is the immutability of its ruleset, enforced by the vast node network of individual users. There’s basically only a way to make backward-incompatible changes if there is a unanimous consensus to do so (e.g., for something like the eventual 2038 problem). Some soft-fork upgrades like Segwit and Taproot make incremental improvements, are backward compatible, and node users can voluntarily upgrade over time if they want to use those new features.
This software’s self-sovereignty and monetary immutability have been lost on other cryptocurrency designers. Based on some of his actions and writings, even Satoshi Nakamoto himself may have yet to fully grasp the near-immutability of his own network. Instead, it’s a property of the network that may have emerged and become realized over time, during and especially after he departs from the project. It’s certainly something I had to experience and research several times before I understood it.
Adam Back, whose 1990s development regarding proof-of-work was cited by Satoshi Nakamoto in the Bitcoin white paper, had this to say about it:
So if every improvement makes an unacceptable trade-off, how can it get bigger? With only a few tens of millions of payments possible per month, how can Bitcoin potentially scale to a billion users?
The answer is layers. Every successful financial system uses a layered approach, with each layer optimal for a certain purpose.
If one layer is attempting to be used for all purposes, it makes too many sacrifices to be useful for almost anything in the long run. But if each layer of the system is optimized according to certain variables to serve a specific purpose (throughput, security, speed, privacy, etc.), then the full network stack can optimize for multiple use cases simultaneously without making unacceptable trade-offs.
For example, in the U.S., we have Fedwire as a gross settlement system between banks. It currently does under 20 million transactions per month (~200 million per year) but settles over $80 trillion in value per month (nearly $1 quadrillion per year) because the average transaction size is massive. Each of these settlements represents a batch of many smaller payment transactions.
We, as consumers, don’t directly use that system. Instead, we use payment methods like credit cards, debit cards, PayPal, electronic checks, and so forth, and our banks record those transactions on their ledger and then settle with each other later. Each Fedwire transaction represents a batch of tons of smaller transactions from higher layers.
In other words, there is the underlying core settlement system and layers on top of it for more throughput, capable of settling billions of transactions per month.
Bitcoin’s ecosystem has evolved similarly, except in an open and peer-to-peer manner.
Bitcoin’s base layer can process up to 400,000 transactions per day. However, each transaction can have multiple outputs, resulting in up to 1 million or more individual payments per day. That’s a few tens of millions of payments per month, or a few hundred million payments per year, around the same ballpark that Fedwire currently handles.
From there, layers can be built on top of it to give it more throughput or capabilities.
For example, the Liquid Network is a federation of dozens of entities that wraps bitcoins in tokens called L-BTC. From that point, L-BTC is faster to move around, has somewhat better privacy, and can support smart contracts, including various other types of security tokens that run on top of it. A large number of L-BTC transactions can therefore be contained within two BTC transactions (one to peg in and one to peg out). The trade-off is that the user has to trust the federation, which is more decentralized than trusting a single entity but less decentralized than trusting Bitcoin’s raw base layer. The majority of Liquid’s functionary federation entities would need to collude against the system to violate user trust.
As another example and the focus of the rest of this article, the Lightning Network is a series of 2-of-2 multi-signature smart contracts that run on top of the Bitcoin base layer. These channels are peer-to-peer or peer-hub-peer and can support many transactions over time for each base layer transaction. The trade-off is that the channel must be kept online to protect the funds and receive payments. Additionally, the network has taken a few years to build up to usable levels of channel liquidity.
And from there, custodians can operate in layers above that for people that want them. Exchanges, payment apps, banks, chaumian mints, and so forth can all provide services to users willing to trust them with a portion of their funds. This can scale Bitcoin usage to any arbitrary level, including connecting with the Lightning Network. Each node on the Lightning Network doesn’t necessarily need to be one person; it could be a custodian with thousands or millions of users.
In that sense, each user interacts with the network in the layer (s) that makes the most sense for their specific needs.
The Lightning Network consists of a series of smart contract channels that run on top of the Bitcoin base layer.
And if you think about it, individual consumer payments make a lot more sense with channels, rather than being broadcast to everyone. If we do an in-person physical cash transaction, it’s directly peer-to-peer. We don’t shout our transaction to the whole world. Lightning replicates that cash concept on top of the Bitcoin base layer.
The result is a much faster, more scalable, cheaper, and more private global payment system, albeit with some trade-offs and limitations compared to directly using base-layer transactions.
Channel-based payments for the Bitcoin network have been explored since the early innings of the network. The white paper on the Lightning Network was written in 2015, and its first implementations came out in early 2018. Developers purposely restricted their channel size early on to grow cautiously and test things out safely in those early years (specifically to avoid the common problem of user funds being exploited, which we often see in DeFi).
The network has been functioning and growing ever since. By late 2020 the network reached a level of liquidity, usability, and critical mass that became quite interesting to me from a macroeconomic perspective.
Using a broadcast network to buy coffee on your way to work daily is a terrible idea. A blockchain is meant to be an immutable public ledger. Do I really need to broadcast my coffee transactions to tens of thousands of nodes around the world to be held in a distributed database for the foreseeable future?
What if I want to buy something more personally or politically sensitive than coffee? Shouldn’t I use peer-to-peer payment channels for that instead?
Imagine, for example, if every email sent on the internet had to be copied to everybody’s server and stored there rather than just to the recipient. That would be grossly inefficient. And yet, that’s how various high-throughput blockchains try to work regarding money.
Instead, I can open a channel on top of the broadcast network, pay for things that only me and the merchant know about (subject to some privacy caveats that will be mentioned later), and then close the channel with no immutable public record of those individual payments having occurred.
Any network that tries to scale transaction throughput on the broadcast-oriented base layer by radically increasing the block size and/or block speed makes no sense. The node requirements become absurdly high, which turns the network into a centralized Visa-like enterprise-scale database with just a handful of massive nodes. Changes can be made to the fundamental rules of the system at any time with the agreement of a handful of major node-running enterprises, and thus all future aspects of the system, including the supply of coins or who to censor the transactions for, becomes changeable. Privacy becomes very hard; various entities could track your net worth and payment history, which is bad enough in a benign environment and terrible in an authoritarian environment where half the world lives.
Additionally, a channel transaction will generally be faster than a broadcast transaction since it inherently requires propagation time to go through a broadcast network, even among the blockchains with the fastest block times.
That’s why every blockchain that attempts to scale transaction throughput too much on the base layer is inherently flawed. Bitcoin Cash, Bitcoin Satoshi Vision, Litecoin, Dogecoin, and other coins like this all sacrifice too much and become too centralized to do something that needs to make more technical sense in terms of scalability or privacy. In the long arc of time, they offer nothing of value.
The only way scaling makes sense and avoids sacrificing decentralization is to use a layered approach. Users can then pick their own solution, the layer (s) that make sense for them, depending on their specific needs.
Want to transfer a sizable amount of value permissionlessly or hold coins for a long time in self-custodial cold storage with the highest-possible security and immutability?
Use the Bitcoin network base layer.
Want to make a lot of instants, cheap, private, permissionless payments using a self-custodial solution, albeit with occasional on-chain transactions to open or close a channel?
Use the Lightning Network self-custodially. Various technologies, including Blockstream’s Greenlight and mobile applications, make this increasingly easy to do by abstracting most of the technical details away from the user while still having the user retain their own private keys. Or if they want to be hands-on, they can be.
Want to make super easy permissioned payments for free and potentially get other perks but at the expense of giving up custody?
Use a custodial service like Cash App, which uses the other two layers. And maybe in the future, there will be more private custodian solutions in the Bitcoin network ecosystem, like federated chaumian mints that use blind signatures. Federated custody options will potentially be more available, which spreads out custodial risk.
Each layer builds upon the lower layer without reducing the qualities of that lower layer. A broadcast network on the base layer, a channel network on the middle layer, and a custodian ecosystem on the upper layer gives each type of user whatever they are looking for. If growing pains become apparent, other scaling technologies may come into play in the future to further increase the number of people that can interact self-custodially with the system.
Bitcoin uniquely came into existence and is purposely hard to change, making it a decentralized digital commodity rather than a centralized digital equity. Instead of trying to create something separate, developers can build on top of it.
Suppose you and your friends are spending a long evening at a bar.
Rather than get your payment method for every round of drinks, it’s preferable to open a tab with the bartender and settle it at the end of the night. If the bartender doesn’t know you, you can offer your credit card information ahead of time so they can charge it later that night.
In a manner of speaking, you and the bartender open a payment channel with each other. There is a moment of friction when setting up the tab and a second moment of conflict when closing the tab. Still, between those moments, there is no payment friction for individual rounds of drinks because you just need to tell the bartender, “Another round of drinks, please” and it happens.
That’s how the Lightning Network works, conceptually. I can open a channel with someone else with a base layer Bitcoin transaction. This channel is a 2-of-2 multi-signature channel, meaning we both have to agree on it. It’s designed so that we can unilaterally close the channel if we need or want to (although we should do a cooperative close). While the channel is open, we can transact any number of times, as long as we have sufficient liquidity in the channel, until one or both of us want to close the channel with another base layer bitcoin transaction.
Unlike a bar tab, however, a Lightning channel is not based on trust or debt. Payments within the channel are updated instantly, and the ongoing tab can be enforced by either party closing the channel and reconciling with the base layer, with each side receiving its current balance. There is no debt, no promise to pay later, from one person to another. It’s like instantly transmitting money to the bartender’s account through the channel whenever you ask for another round of drinks.
Let’s take this a step further. Alice has a tab with the bartender at a bar, and another person, Bob, also has a tab open with the same bartender. If Bob wants to buy Alice a drink, he can tell the bartender to give Alice a drink and put it on his tab. Alternatively, if Bob forgot his wallet and needed money to get home, Alice can tell the bartender to give Bob $30 and put it on her tab. Alice can pay Bob through the bartender, even though Alice and Bob know nothing about each other and have no payment channels open with each other.
The Lightning network does that, too, but without debt or trust. The following is an example diagram.
If user A wants to send a payment to user Q, she can do it by routing the payment from A to C to F to K to L to Q. Each node in the middle might charge a tiny routing fee, like a fraction of a penny since it’s easy to automate.
She doesn’t need to set up a channel directly with user Q.
Because it uses onion routing technology, the nodes in the middle don’t necessarily know where the payment originated from or where it is going to its final destination. Node K is told “route this payment from F to L” without being told more than it needs to know.
The end result of this network of channels is that one base layer transaction gives you access to a large number of individual payments to various separate entities. Thus the Bitcoin network can be scaled rather significantly.
Imagine a global system with a massive number of interconnected nodes. Anyone can enter the network with a new node and start creating channels. Alternatively, many custodial services also give account holders access to the network through their nodes and channels.
Here’s a visualization of the public Lightning network at the moment. It’s a growing network of interconnected nodes connected by payment channels, with those bigger dots representing exceptionally well-connected nodes:
And here’s a zoomed-in shot of the bottom left area to show a random sample of the shape of connections that is typical throughout the network:
Since the network is pretty efficient, transaction fees are often the equivalent of a penny or less.
There is no hard limit to how big the network can get over time and how many transactions per second the network can handle other than the fact that opening and closing channels result in base-layer transactions. The Lightning Network, if it gets to the size of having millions of open channels in the future, can theoretically handle an almost unlimited number of peer-to-peer transactions per second. Still, there’s an upper limit of tens of millions of new channels that could be opened per year (depending on what percentage of base layer transactions are channel openings).
Although it has some constraints, especially in this early development phase, this type of network makes a lot of sense from a payments perspective. Peer-to-peer channels are better than broadcast networks for small individual transactions. They’re fast, cheap, and relatively private.
Plus, the network can do micropayments much smaller than what Visa and Mastercard can do. With Lightning, you can send payments worth a fraction of a penny. This opens up new use cases that aren’t possible with credit cards, such as machine-to-machine payments, the streaming of micro-payments, or the usage of micro-payments as a spam-prevention technique.
All of this is global and permissionless. Users can do it without asking the permission of a bank or other central entity. To prevent it, governments need to actively tell their citizens that it’s illegal to use certain types of free, open-source software and then figure out how to actually enforce that.
Liquidity is the biggest limitation of a network that relies on individual routing channels.
If there are only hundreds of participants, it could be pretty hard to find a route that connects any two arbitrary nodes and has enough liquidity on each channel in the path to pass the payment through. A lot of attempted payment routes will fail. The funds won’t be lost, but the transaction will fail to initiate. The network will be limited, and the user experience will be poor.
Once there are tens of thousands, hundreds of thousands, or millions of participants, and with larger average channel balances, routing a payment from any arbitrary point to any other arbitrary point on the network becomes exponentially easier and more reliable. There is a very large number of possible paths between most points on the network.
In the Lightning Network, the larger the payment you want to send, the harder it will be to find a set of channel paths that collectively have enough liquidity to handle that payment. For example, it’s pretty easy to send the equivalent of $25 between two points on the network because your software merely needs to find a set of interconnected nodes that end up each with at least $25 worth of liquidity in the direction you want. However, sending the equivalent of $2,500 to many destinations is harder because there are fewer channels with that much liquidity. Instead, your payment may need to be sent in parallel through multiple paths. So there must be many possible paths between your node and the target node. Additionally, the target node may simply not have enough total inbound liquidity to receive a payment of that size.
The more channels exist, and the bigger the channels are, the more reliable it becomes to route larger payments.
Due to this dynamic, the Lightning Network isn’t a light switch that could just be turned on and work perfectly from day one. Over the years, it had to be painstakingly built, channel by channel. The early users were high-conviction developers and early adopters working their way through a difficult-to-use network, and only after they spent years working on it did it become relevant for a typical user who just wants cheap and fast payments. Initially, they limited channel sizes and payment sizes for user safety. Think of them as slowly hacking raw paths through the jungle with machetes so that one-day roads may be built for civilization.
Furthermore, tools had to be built along the way to make it easier for node operators to manage liquidity optimally. Those have gotten better, but it’s still a work in progress.
Many critics said the network would not work, and once it was implemented, many people for the first couple of years said it was a dud. Most of them, however, needed to understand how it grows. The Lightning Network is like one of those giant freight trains with miles of cars behind it; it takes a ton of work to get up to speed from a standstill, but then it’s practically unstoppable once it gets going with tremendous momentum.
As the Lightning Network becomes more usable, the companies building implementations or applications for it can raise more capital from interested investors. For example, Lightning Labs raised a $70 million series B round in 2022 to continue building the Lightning Network infrastructure. Zebedee raised $35 million (including from game giant Square Enix) to continue building solutions for games to incorporate Lightning micro-payments. There have been hundreds of millions in total capital raised over the past few years for wallets, apps, infrastructure, and more.
Then, entities with a large number of users can connect to it. Bitfinex and River Financial integrated Lightning for their users in 2019. Bull Bitcoin and Okcoin integrated Lightning for their users in 2021. Cash App and Kraken integrated Lightning for their users in 2022. Tens of millions of people now technically have access to the Lightning network if they want it. A lot of merchant software accepts it now too.
By January 2021, I noticed that the network was starting to reach a critical mass of liquidity and usability. Lightning was becoming truly usable, meaning that payment routing was becoming more reliable. The initial capacity of the network was bootstrap liquidity and wasn’t efficiently allocated. For a while, the network looked from the outside like it wasn’t growing when that liquidity was slowly spreading out to become more usable and efficient. And then, boom, liquidity, and payments started to take off, and some excellent mobile apps came to market.
No company controls the Lightning network. It’s an open-source set of participants.
The basic foundation of the network is an agreed-upon minimal protocol, which makers of Lightning node software adhere to if they want to operate with each other and the network as a whole. These standards are like basic email standards or basic internet standards for various applications to communicate with.
Lightning node software is referred to as a Lightning implementation. Lightning Labs, Blockstream, and Block Inc are the businesses responsible for the three biggest Lightning implementations or implementation tool sets that various developers use.
If you want to be hands-on, you can choose which implementation to use, customize an implementation, or even build your own implementation from scratch. No gatekeeper stops anyone from building their own lightning implementation and using it to interface with the rest of the network; it’s an open protocol.
From there, many companies can incorporate these Lightning implementations into easy-to-use apps. An end-user won’t directly use a Lightning implementation; they will use a mobile app that allows them to connect with the network and obscure most of the technical details from them, including the details of the Lightning implementation under the hood.
Some apps can be custodial, meaning you trust a company with your money. Cash App and Strike are examples of this. This comes with specific amounts of regulatory compliance in various jurisdictions.
Other apps can be self-custodial, meaning you have complete control over your coins. They are just using their open-source software and connecting with highly-liquid nodes. Muun and Breez are examples of this.
When the initial network implementations were launched, few merchants accepted Lightning payments.
Over time, it became easier. BTCPay Server and OpenNode, for example, allow merchants to easily accept Lightning payments.
When El Salvador made bitcoin legal tender, large companies like McDonald’s and Starbucks could quickly integrate Lightning payments using third-party software.
NCR Corporation and other point-of-sale companies have expressed interest in becoming interoperable with the Lightning network. Square is a large point-of-sale software and equipment provider for small and medium-sized businesses, and its parent company Block Inc is one of the most pro-Bitcoin companies. Their Cash App already integrates with Lightning, and they have multiple Bitcoin-focused development units.
Over the next several years, it will be increasingly common to have Lightning as a payment method. Some merchants will convert to dollars immediately upon sale (which is easily implemented by many point-of-sale software providers). At the same time, some will choose to directly accept Bitcoins over the network and keep them.
For a couple years now, interest has increased in using the Lightning Network to transfer dollars or other currencies.
The idea is that Bitcoin is an increasingly liquid asset that trades in most large currencies. Someone can exchange dollars for Bitcoin, send Bitcoin over the Lightning Network to another custodian in some other country, and then exchange it back into dollars, all within a couple seconds. This allows someone to use Lightning’s payments aspect separately from Bitcoin, the volatile asset.
This can be done with other currencies as well. Someone can exchange pound sterling for Bitcoin, send the Bitcoin over the Lightning network, and then exchange that Bitcoin for euros within seconds.
This is a very cheap and fast way to send global payments, and businesses like Strike and Bottlepay have been using the network for these purposes. That fiat-to-Bitcoin-to-fiat method can eliminate tax issues associated with Lightning payments for the end user while using the fact that Lightning is more cost-efficient than most payment networks, such as Visa and Mastercard.
This month, the European Central Bank even published a report that examined the Bitcoin/Lightning stack among several potential methods for global cross-border payments and took the network pretty seriously in their analysis.
Due to the November 2021 Bitcoin soft fork upgrade called Taproot, the Bitcoin network, particularly the Lightning Network, can theoretically be used to send other types of assets using the Taro protocol. The Taro protocol was announced in April 2022 by Lightning Labs and is being tested and eventually implemented.
For example, when this is active, a USD collateralized stablecoin asset can be issued, which can then be sent nearly instantly and nearly for free across the Lightning network. This means that a user can pay for things nearly immediately and for free in an asset with less volatility that doesn’t trigger taxable events.
“Imagine Alice and Bob have a Lightning-USD (L-USD) channel with $100 of capacity, balanced such that they both have $50 worth of inbound liquidity, and Carol and Dave have a L-USD channel with $100 of capacity, balanced such that they both have $50 worth of inbound liquidity.
If Bob only has a BTC channel with Carol, Alice can still send $10 of L-USD to Bob, who charges a small routing fee in BTC and forwards $10 of BTC to Carol, who charges a small routing fee in L-USD and forwards $10 of L-USD to Dave, the final destination. Taro interoperates with the existing BTC-only Lightning Network as-is, only requiring the first hop and the second-to-last hop to have L-USD liquidity.
This structure taps into the network effects and liquidity of today’s Lightning Network to route any number of assets, avoiding the need to bootstrap an entirely new network for new assets and ensuring that bitcoin underpins all transactions on the network. It also incentivizes the growth of BTC liquidity within the Lightning Network to serve a broader multi-asset Lightning Network.”
Notably, the network’s core remains focused on Bitcoin channel liquidity. In contrast, specific Taro assets would generally be on the network periphery. This avoids fracturing overall network liquidity since it’s all moving through Bitcoin channels for most of its path through the network’s core.
Various point-of-sale technology providers can eventually integrate this as well, so stablecoins can be used to pay for things over the Lightning Network in addition to Bitcoins.
Paolo Ardoino of Bitfinex provided a good summary of the technical limitations of incorporating super-fast payments on a broadcast network and why stablecoins on Lightning should significantly improve.
A user could have either a custodial or self-custodial mobile wallet, where they hold bitcoins and stablecoins in one app and use them to pay for things as desired.
With various multi-signature implementations, time locks, and other programmable surfaces, there are plenty of novel ways to move money around and use the network for multiple purposes.
In 2021, a company called Impervious released an API allowing people to make applications that run over the Lightning network.
In addition to sending value instantly and cheaply, the Lightning Network can be used to send non-monetary information. This has potential use cases for social media messages, video calls, file sharing, identity verification, content monetization, social networks, and other applications. In 2022, Impervious is working on a browser that brings a lot of this together in one place.
Lightning can also be used for spam resistance. Adam Back developed proof-of-work money in the 1990s in the form of Hashcash, an anti-spam technique. Some analysts are now pointing towards Lightning as an effective way to reduce online spam. There are social networks and websites where commenting requires one sat (0.00000001 Bitcoins) and where users tip each other with sats. This impedes the economics of spammy social media bots because each account and post comes with a micro-price.
With a browser plugin, many websites could implement something like this if the network grows.
Similarly, Strike CEO Jack Mallers implemented a micro-cost for people that want to send emails to him.
With the full stack of Bitcoin, Lightning, and things like Taro and other things, it’s hard to predict what this network could be used for a decade from now. Some things will likely flourish, and others will be duds. It’s a programmable set of building blocks for money and information that moves instantly, permissionlessly, and nearly for free. It’s not controlled by any one company but is open source and can be built upon by any number of companies.
Sometimes this openness creates friction between competing visions for how the network is best used or how to agree on a set of open protocols. Still, it also gives it a lot of power and flexibility.
When the iPhone was introduced in 2007, few people thought, “Wow, this could really disrupt the taxi industry a decade from now.”
A few technologies had converged to that the point where everyday people could have a pocket supercomputer with a big touchscreen and a high-bandwidth mobile internet connection, and this served as a set of building blocks that could exponentially eat into many other industries, including allowing Uber to come along and change how we move across cities. All individual hardware electronic devices became obsolete as they became applications on a smartphone.
The Bitcoin/Lightning stack is similar. The network is still tiny and has a lot of development work to do, and everything is still being determined. But to me, it looks like a robust monetary network with a ton of upside potential over the next decade.
Lightning has faced several criticisms, mainly from proponents of other blockchains. For many of them, the success of Lightning Network could imply the irrelevance of their own project.
There is still a ton of development work to do on the Lightning Network, so some criticisms are fair, and the network does have limitations. The number of developers is pretty small, and the network is only in its fifth year in operational terms, with only the past two years really being at a critical mass of highly-usable liquidity.
But after years of space research, I view Lightning as very promising and generally underestimated. It requires looking out for the next several years to see the potential.
Here are my responses to some of the common criticisms of the network I have seen.
The Lightning Network is growing quickly but still has under 5,000 Bitcoins in public channels. Depending on Bitcoin’s price at a given time, that represents only hundreds of millions of dollars at most. Due to high velocity, quite a lot of transaction volume is being done relative to that tiny amount. Still, ultimately it’s small compared to the global payments industry.
Arcane Research published a great analysis of the Lightning Network’s current scale back in April 2022:
This small size is often compared by detractors to various DeFi applications. For example, Wrapped Bitcoin on Ethereum has over 230,000 Bitcoin custodial. Lightning, therefore, looks very small, outmatched, and even trivial by comparison. However, that comparison is a category error.
The overall market for actual crypto medium-of-exchange payments, in Bitcoin or otherwise, is still tiny. As discussed earlier, the widespread use of Bitcoin as a medium of exchange should not be expected until later in its monetization process, especially in developed markets where every transaction is a taxable event. People have access to much more established payment systems.
DeFi, on the other hand, is mainly used for trading and leveraging. Many of these blockchains and Defi protocols have strong crypto VC incentives to issue a coin, market it and pump up the price and exposure, and then get fast exit liquidity on retail investors.
Chainalysis found back in that DeFi is mainly used by institutional-sized traders.
It makes more sense to compare the amount of Wrapped Bitcoin (which is held by a centralized custodian) to the amount of Bitcoin on centralized exchanges. There are more bitcoins wrapped on Ethereum DeFi than on Kraken or Gemini, for example, but fewer than on Coinbase, Binance, or Bitfinex. That’s a more appropriate comparison; Ethereum is basically the fourth largest Bitcoin exchange and leveraging service, and trading+leveraging is a much larger Bitcoin market than Bitcoin merchant payments at this point in time.
Lightning, on the other hand, has no separate coin. Nobody is getting super rich quickly off of Lightning. There is no huge set of marketing incentives to get people on Lightning. It’s a rather boring payments network, frankly. It has a very low speculation-to-utility ratio, meaning that it’s almost all utility. I personally consider it to be rather exciting, but that’s because of the utility that it offers and the elegant way in which it works.
Additionally, Lightning developers purposely limited payment and channel sizes in the early years to reduce the potential for people to lose significant amounts of money from potential bugs or exploits in its nascent state. Developers' goal was never to grow quickly at all costs; the goal since the beginning was to build responsibly for the long run.
Lightning’s growth, including through a bear market, is mainly due to organic utility and the need for it, rather than primarily for speculation, trading, leveraging, or for any sort of pump-and-dump VC-funded incentivization scheme that relies on using retail investors as exit liquidity. Some catalysts, such as Taro (e.g., dollar stablecoins on Lightning), could accelerate the network’s growth at some point. Either way, it’s a growing network for people who want to transact using the Bitcoin network.
The Lightning Network can be challenging to use at a deep level, especially if you intend to be a high-volume routing node. Your node has to be on all of the time, you tie up a lot of capital, and it can be tricky to balance your liquidity.
As a result, the network naturally developed many super-nodes that serve as hubs for network traffic since they have significant capital and spend a lot of time building and maintaining liquid channels. Some people refer to this as a hub-and-spoke model, which is only somewhat true in this context. This seeming centralization is often used as a criticism of Lightning, but that criticism is misplaced.
For a hypothetical example, suppose you only have one or two fiber optic internet service providers in your area, and those two companies are the only possible ways to access the Internet. That’s a major centralization problem; you’re completely at the whim of those one or two companies to let you use the Internet, and you have no recourse otherwise unless you move. You’re limited to the one or two hubs that serve your area in a monopoly or duopoly fashion.
Instead, suppose hypothetically that you could choose to use hundreds or thousands of satellite-based internet providers. In this thought experiment, they can connect you to the global Internet wherever you are via a fleet of orbiting satellites. This removes any centralization problem; you can pick any of them from around the world, and they are nearly countless in number. You’re not limited to a specific hub linked to your location; you can pick from the entire global set of hubs, and you can even pick more than one hub simultaneously for additional redundancy.
In the Lightning network, there are all sorts of super nodes that you can connect with for routing liquidity, and they are based in various jurisdictions or can operate privately. Since it’s all software, it scales rather significantly.
Additionally, you can avoid directly connecting with any of the super nodes if you don’t want to and instead connect directly peer-to-peer with other small nodes (including internationally), who are themselves connected to any number of other peer nodes or super nodes. There are online groups, such as Plebnet, with 6,000+ members, that focus on building channels with each other and supporting each other. This makes it not really a hub-and-spoke model, even if there are many particularly well-connected super nodes throughout the system.
Importantly, entities in Lightning are not enforcing the immutability of the money supply or enforcing other consensus rules; they’re merely routing individual payments.
If certain super-nodes are perceived as problematic in terms of privacy or in terms of censoring transactions, users can build channels around them. That optionality is the key to decentralization. The Lightning Network involves an evolving set of nodes and channels, with old channels being removed and new channels being built as needed by its participants. Market forces dictate where the liquidity goes.
This was how the Internet looked back in 2005:
And here’s that zoomed-in snapshot of part of the Lightning Network that I showed earlier, which shows how similar its structure is to the Internet, except that Lightning is more decentralized because any individual node can directly connect to many other nodes, in addition to routing payments through super-nodes if they want.
Lightning need not be unique to Bitcoin. Much like how the Bitcoin network can incorporate potentially useful technology developed on other blockchains, specific blockchains can incorporate Lightning-like technology on their stack.
In fact, some Lightning-like networks exist on some other blockchains, but they are tiny compared to what exists on the Bitcoin network.
This is because, as previously described, Lightning relies on liquidity. Liquidity (in the form of many well-funded channels) is one of the key limitations for it to work smoothly. When the network was first launched on the Bitcoin network, it could have been more usable. There were very few nodes and channels, and finding a payment route to send payments through or to get inbound liquidity so that other people could send payments to you was challenging. A lot of payments would fail and need to be re-attempted. It was a work in progress, basically in alpha development.
However, it gradually built up more and more channels for years, which made it increasingly reliable to send and receive payments. Liquidity is a major network effect variable; it’s why certain stock and commodity exchanges remain the primary stock and commodity exchanges for decades or even centuries. People go to where liquidity is, which creates more liquidity, which brings more people, and that creates more liquidity. Lightning has a self-reinforcing network effect that is extremely hard to replicate, and it’s growing month by month.
This is why the Lightning Network is like one of those mile-long freight trains. It takes a lot of work to start and accelerate it. But once it’s going, its momentum is huge. The Lightning Network took years of channel building and cautious development to reach a critical mass of liquidity and true usability. It did so largely because it was built on Bitcoin, which has the biggest combination of liquidity, scale, and decentralization of any cryptocurrency.
Lightning is a network effect built on top of a network effect, and both reinforce each other.
The Lightning Network generally offers better privacy than the Bitcoin base layer, especially for the sender. Still, it could be a more perfectly private network.
As previously mentioned, the network uses onion routing so that each node along the payment path only knows the directions that apply to them rather than the full set of directions for where the payment originated and where its final destination is. It’s a series of directions, but each participant only has a small subset of the total directions.
For example, using this diagram again, if I send a payment from A to Q through nodes C, F, K, and L, those nodes don’t necessarily know that Q is the final destination and that A was the initial sender.
Node K, for example, is just being told to receive payment from F and send payment to L in exchange for a tiny fee.
An entity trying to spy on transactions can set up multiple Lightning nodes around the network and serve as a payment router. Usually, an individual node doesn’t know the original source or destination of payment, only the node where it came from and where they are sending it to. However, if an entity has enough nodes across the network, it might be able to get a good idea of where certain payments are coming from and going. So, only some payments absolutely guarantee perfect privacy, although the sender usually has good privacy in practice.
Knowledgeable users have significant ways to maximize their privacy, both on the Bitcoin network’s base layer and the Lightning network, but these do take some know-how. There is still development happening in this early stage of the network to expand privacy options for users and to make privacy more natural. The Human Rights Foundation has a Bitcoin Development Fund that, among other things, funds various privacy developments.
Most people living in the U.S., Europe, or Japan do not have problems making payments or getting bank accounts regularly. They may wonder why Lightning is relevant at all.
However, a significant portion of the world is unbanked. At the same time, a free, open-source software app that uses the Lightning Network can give them payment capability. Many of the developing world suffers from persistent double-digit inflation, and most people in developing countries have experienced major currency devaluations/resets in their lifetimes, eradicating savings.
Additionally, approximately half the world lives in countries classified as authoritarian or semi-authoritarian. They face arbitrary bank account freezes for basic things like protesting or speaking too freely. Technology like the Bitcoin/Lightning stack is an asymmetric technology for them.
Even in relatively free countries, individual people, companies, or industries can be de-platformed from the common payment networks despite not doing anything illegal. Therefore, the Bitcoin/Lightning stack is a backup option open to all.
When imagining the potential addressable market of the Lightning network or similar solutions, we need to think globally rather than just about our own comfortable lives. People who suffer from high inflation, corrupt banking systems, de-platforming, and other monetary problems, are the more natural prospective users of peer-to-peer money that can’t be debased or frozen by a centralized third party. They’re more likely to get on the Bitcoin/Lightning network than any given person in a developed country.
Sure, some bad actors can use that technology as well, but that’s like saying that bad actors can use the Internet. Of course, they can; it’s an open set of protocols. Any powerful piece of technology can be used by good or bad people. However, the number of people needing improvements in this area for legitimate purposes is orders of magnitude larger than prospective criminals.
It’s not shocking, then, that 19 out of 20 of Chainalysis' top countries by cryptocurrency adoption are developing countries. In many of these countries, there is a much higher penetration of smartphones than bank accounts:
Even in developed countries, Lightning can make payments cheaper and be used for micropayments or machine-to-machine payments more seamlessly than the current fiat payment methods.
Lightning greatly increases the transaction volume that is possible on the Bitcoin network. However, opening and closing a Lightning channel still requires an on-chain transaction, which means that in its current form, the Bitcoin/Lightning stack still can’t scale to billions of people using it self-custodial.
Specifically, there are block space limits to how many people can use it fully self-custodial regularly unless certain base layer forks allow for more throughput.
For any network, there are inescapable technical trade-offs. To ensure the widespread auditability and immutability of the base layer, some constraints are hard to overcome.
Many other blockchain designers are trying to over-engineer their systems. Any solution needs to have a product-market fit. Not everybody wants a fully self-custodial experience. Some people want the convenience of using a custodial service of some sort. Bitcoin/Lightning gives optionality to people around the world. Still, people can see fit to use whichever portion of the stack they want.
To quantify it, the Bitcoin/Lightning stack can be semi-regularly used by tens of millions of people self-custodial (or more than that over time if many of them are just holding it in cold storage). Custodial services can scale that to higher numbers. For example, all of the tens of millions of accounts on Cash App technically have access to the Lightning Network through nodes and channels operated by Cash App. The same is true for people on Strike, River, and similar apps.
At the current time, the Bitcoin network is being criticized by some opponents for low fees and thus supposedly low long-term censorship resistance as the block subsidy winds down (meaning there is not overwhelming demand for its block space at the current time, which if that state were to persist indefinitely could eventually result in a low cost to control half of the mining share). In contrast, it is simultaneously criticized for being unable to scale self-custodial to everyone in the world (meaning its block space is not nearly big enough to fulfill such enormous potential demand). These are mostly mutually exclusive concerns.
If the combination of the Bitcoin/Lightning stack eventually reaches severe growing pains against the number of people that want to interact with it fully self-custodial (a good thing), then there are still some areas of development that can potentially increase it’s scaling potential, via ways to allow more users to share a given channel, which is beyond the technical scope of this article.
On the other hand, if the network doesn’t grow much and its block space does not increase in value (a bad thing), then its scaling limitations are a non-issue.
Currently, the Bitcoin/Lightning stack provides tremendous scaling potential compared to the number of people that currently use the network. The network doesn’t need to overbuild for market conditions that don’t exist yet. Of course, it’s good for developers to think about long-term scaling options.
As the saying goes, “Necessity is the mother of invention.”
If/when the network encounters persistently high base layer fees, tons of base layer transactions being used to open lightning channels, and an inability to onboard all of the users that want to onboard to the network self-custodial, then that would spark more interest in developing further scaling solutions, including the possibility of new broad-consensus soft forks and other changes.
For thousands of years, commerce and money moved at the same speed: the speed of foot, horses, and ships. People’s ability to do transactions, and the bearer assets they transacted with (mainly gold and silver), had no inherent difference in speed.
With the invention of the telegraph and then the telephone and undersea cables throughout the 1800s, commerce increased to nearly the speed of light. People could transact across continents by updating each others' bank ledgers over telecommunication systems.
However, gold and silver, as bearer assets, still moved slowly and thus had to be increasingly abstracted to keep up.
Before this, gold and silver were already sometimes abstracted with paper claims due to divisibility limitations. Still, once telecommunications technology was invented, their slow speed made it even more necessary to abstract them. Eventually, governments dropped gold and silver backing from their bank ledger and physical paper abstractions entirely. The difference in speed between commerce and bearer asset money gave governments a huge opportunity for custodial arbitrage.
The invention of the Bitcoin Network, and especially the Lightning network that makes use of it, however, re-created a way for bearer assets to move at the speed of telecommunications, just like commerce does. People now have the option to store and send liquid value globally, peer-to-peer, without relying on claims or IOUs, by instead relying on decentralized code-enforced rules that immediately put the funds in the recipient’s custody.
The Bitcoin/Lightning stack is a decentralized ledger with peer-to-peer payment channels interwoven on top of it. It’s programmable money in a decentralized cloud, connected to the real world via its proof-of-work consensus.
It’s hard to say exactly where this leads. Peer-to-peer global transfers of liquid value are Pandora’s box that has now been opened. Certain governments do not want it open and pass various laws against it, but here it is, with free open-source software. It’s much harder for governments to enforce payment rules on millions of individuals than on just thousands of highly-regulated banking institutions. If people don’t need to go through banks to transact inside or outside of their local area, that opens a new set of possibilities.
There’s a race now between public and private developers.
On one hand, things like the Bitcoin/Lightning stack are racing ahead with stateless monetary assets and cheap and instant payment channels. Since it’s open source, developers around the world can work on various parts of it to any extent they want. Combined with how finite of an asset bitcoins are, this is leading to substantial adoption and development, even as the price fluctuates wildly based on leverage and big investors and all sorts of reasons. Individuals, startups, and even some large corporations contribute to development efforts.
On the other hand, governments are working towards central bank digital currencies. Some of them, like China, got a head start and already have implementations in the field. Most other governments are way behind and are only in the research phase for how they might want to construct a digital currency.
While governments are slower than the open source private sector and have a less attractive set of incentives (maintaining an inflationary system, maintaining seigniorage with the system, enhancing surveillance and control capabilities on the users of the system, and so forth), they do have the power of taxation and regulation over their open source private-sector competition.
However, this power of taxation and regulation is limited by their rule of law, the will of the people, and their desire to encourage innovation-focused businesses to remain in their jurisdiction rather than go elsewhere in the global marketplace.
At the end of the day, blockchains are information. Users are merely updating an open-source distributed public ledger amongst themselves. They can simply memorize a twelve-word seed phrase to interact with it. To outright ban the individual use of open-source blockchain software is basically to ban a form of speech and information. This is somewhat possible in authoritarian regimes (although underground usage of it continues) but is more challenging to do in a country with property rights and freedom of speech and expression, with democratic representation. Governments have to get rather authoritarian if they want to nearly completely deter the use of such open and decentralized technology and then maintain that deterrence perpetually.
Instead, the main ways policymakers can control the industry are via on-ramps, taxation, and regulation. They can block fiat bank connections to digital asset exchanges or regulate their usage with strict KYC AML compliance checks in and out of large digital asset exchanges combined with blockchain surveillance to track addresses. They can make it hard to serve as a custodian for digital assets or make it hard for users to withdraw coins from custodians. There are ways around this, but all of these are frictions and control points for large pools of capital.
In problematic jurisdictions like Turkey, with massive inflation, or Russia, with authoritarianism, they are more prone to say that it’s illegal for merchants to accept Bitcoin or other digital assets as payment for goods and services and force people to try to use their fiat currency instead. But to the extent that they can even enforce such rules, they do so at the risk of cutting off their population from the rest of the world, using ever-stronger means of controlling information and open-source software, and deterring innovation from happening within their jurisdiction.
In several countries with a failing currency, having and using cash dollars is illegal. And yet cash dollars are often accepted by merchants anyway. It’s very hard to enforce a cash dollar ban when people need help using the local currency due to high inflation or transaction censorship. Similarly, it’s rather hard to enforce a perpetual ban on open-source software and peer-to-peer digital transactions; the number of enforcement points is huge, and developers keep adapting it to make it easier and more private to use.
The digitization of money is a key theme for the 2020s decade and beyond, both in bottom-up ways (e.g., bitcoins) and in top-down ways (e.g., central bank digital currencies). I am interested to see the directions that it goes in.
The Bitcoin/Lightning stack, in particular, continues to be promising as a monetary network, with ongoing signs of user adoption and development and high levels of decentralization. It’s not without risks, but it’s certainly something to keep an eye on.
Special thanks to Elizabeth Stark of Lightning Labs for answering so many research questions; this piece wouldn’t be possible without her.
And additional thanks to Dario Sneidermanis of Muun for answering questions about Muun and UX and scaling when I met him in Oslo, Alexander Leishman of River Financial for answering questions about liquidity, Roy Sheinfeld of Breez for publishing great research regarding the network, Kevin Rooke for interviewing a large number of Lightning experts on his podcast, Obi Nwosu of Fedi for educating me on the concept of federated Chaumian mints, Alex Bosworth of Lightning Labs for his social media posts about liquidity, the team at Arcane Research for putting out detailed reports on the state of the network, and of course all of the developers and financiers in the ecosystem for building the network out and providing articles or documents to learn from.
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Lyn is an investment strategist at Lyn Alden Investment Strategy. She holds bachelor’s degree in electrical engineering and a master’s degree in engineering management, with a focus on engineering economics and financial modeling. Lyn has been performing investment research for over fifteen years in various public and private capacities.
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