Lightning Network, age 4
An entire industry has blossomed around a collective commitment to Lightning Network.
Is it “the Lightning Network” or simply “Lightning Network”? I prefer it without the “the.” As in, I believe Lightning Network has forever changed bitcoin. Or should it be, I believe the Lightning Network has forever changed bitcoin? Send me a message and tell me how it should be written!
Today’s post is inspired by the latest research report published by Arcane Research (writer) and OpenNode (data provider and sponsor) on Lightning Network (LN). When I first started writing about LN four years ago, the network had just been birthed. Here was the abstract from that paper from 2018:
Lightning Network provides a framework to measure the time-value of bitcoin, a precursor for a capital market and reserve currency status. Observable variables in Hashed Time Locked Contracts can be used to calculate the interest rate received on bitcoin held in payment channels, allowing investors to measure their opportunity cost of capital. Lightning Network wallet software should include ways to calculate interest and prove the rate received in a trust-minimized way. A reference rate should be developed akin to US Dollar LIBOR, using consensus to dictate how the rate is calculated. This reference rate can anchor off-chain bitcoin lending into the global economy, leading to bitcoin-denominated banks, credit ratings, debt capital markets, and eventually an entire financial system: a path toward status as a global reserve currency.
And it’s all coming true.
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Now, with the release of Taro, a new transaction protocol that uses LN, I feel like it’s 2018 all over again and I’m following Alex Bosworth for hints on the how the time value of bitcoin can be unlocked by LN. This tweet from last week left me with more questions than answers:
I’m operating with the information that credit issuance is a potential use case for Taro, so I’m starting to speculate that an entire fractional reserve banking industry can now be built using bitcoin as collateral sent through LN, for better or for worse. More on this later in the post.
The Arcane/OpenNode report left me with some important takeaways:
The network is handling millions of payments per year with ease.
Annual volume is not yet close to $1 billion, which is very tiny from even a bitcoin perspective.
LN payment volume is now highly sensitive to exchange flow.
It’s fair, first and foremost, to celebrate LN’s early success. At age 4, the network has most importantly achieved consensus among industry participants as bitcoin’s official scaling solution—the optimal way to instantly settle bitcoin transactions without using a central party, only a second-layer protocol on top of the bitcoin protocol. LN proved itself early in 2018 as a functioning smart-contract standardization, advancing bitcoin past one of its most annoying shortcomings: scalability. And the network has come a long way since then. Here is a graphic from the report showing millions of transactions in 2021 and fast approaching a million transactions on a monthly basis (gray line):
The other metric on the graphic, payment volume measured in dollars, shows a network that is still very young. The annualized volume is still less than half a billion dollars, an enormous accomplishment for LN and every person and company that helped it reach that level, but the amount is dust relative to the trillions ($4.2 trillion in 2021, according to a research report from The Block) that now move on bitcoin’s blockchain every year.
My most noteworthy takeaway was how the report explicitly breaks down payments that are involved with an exchange (gray line) and payments that are not (black line):
The report provides the data like this because trading now materially affects overall LN volume, a situation that will only persist as more exchanges (the latest being Kraken) join the Lightning Network. The evolution of LN users now means that headline LN volume will be acutely sensitive to bitcoin trading volume, which is itself sensitive to bitcoin price volatility. While LN is essential to the burgeoning bitcoin-native online consumer economy, payments that are part of exchange flow should dominate, by volume, the rest of the network. And that is entirely ok, as trading is still bitcoin’s most important use case.
What to watch for in LN
LN is still in its early stages, even though enthusiasts like myself have been shouting from the rooftops about it for almost half a decade. While surreal to type “half a decade,” this must be what bitcoin enthusiasts felt like in 2013 after five years of bitcoin’s existence. Painfully obvious to them, yet far away from the mainstream view. Today, I do believe that bitcoin’s permanence is becoming a mainstream view, but most people still have never heard of LN. If Tesla buying bitcoin in 2021 was bitcoin’s mainstreaming moment (I believe it was), LN’s mainstreaming moment hasn’t happened yet. It will.
I’m specifically watching Taro, and how LN looks to be used as a collateral platform for stablecoins. This is particularly fascinating to me, because from a theoretical perspective, bitcoin collateral moving through LN can be used as a good-faith attachment to USD tokens, which may or may not be linked to appropriate dollar-denominated assets that qualify as reserves. In this way, bitcoin can serve as the reserve layer in a dollar-denominated fractional reserve lending system, one that will assuredly bring its own set of booms and busts to the bitcoin layered system.
I could be completely wrong on my understanding of the Taro protocol’s intention and capabilities, but this is how I’m thinking about it (I do hope that members of the Lightning Labs team or other developers close to the situation will guide me through this as I think aloud). My understanding is that Taro allows for non-bitcoin assets to be attached to sats in a LN transaction. These non-bitcoin assets could be attached to either a handful of sats (the bare minimum to make the transaction work), or they could be attached to a meaningful amount of sats, one that is correlated in magnitude with the attached asset. If $1 million in USD stablecoins could be attached to $10,000 worth of sats, using a 10% reserve ratio of sorts, the sats being used to transfer attached value could be viewed as the reserve layer for credit creation. Before I go any further into this idea, I’ll stop before I have either gone off the rails (as judged by LN devs) or thoroughly confused you, the reader.
The final aspect of LN I’m watching ties back to my original work on Lightning Network interest rates and routing economics: the capital market potential for LN routing is exciting, material, but still not investible in size. LN is still in the “millions” realm, but needs to operate in the “multibillions” realm before it’s a legitimate source of yield for large investors. LN routing today is more a practice in the hobbyist arena than it is an asset class, but over the coming quarters, the data might tell us a different story. I’ll be watching the numbers.
While detectives often find criminals by “following the money,” investors can often find outsized returns by “following the smartest people with the strongest conviction.” I was drawn to bitcoin in 2016 partly because of how many brilliant people were leaving successful careers behind in order to be at the forefront of the bitcoin revolution. I’m watching something similar take place with LN today—the conviction that LN is bitcoin’s scaling solution and only path forward is palpable, and an entire industry has sprung up to prove it:
I’d like to call attention to a handful of companies in the above graphic. This section is less an equity research report for LN-focused venture capitalists, and more a snapshot of some of the companies with which I’m familiar, due to personal and business relationships with founders, staff, and investors. There is an obvious bias in selecting these companies to profile, but my main objective here is to demonstrate to readers that the people I know at these companies are committed to the next twenty years of Lightning Network, not trying to make a quick buck “in crypto.” These people are serious, smart, and now have multimillion dollar investments on the line, and they are all in on LN as the future of both bitcoin and online economies.
Lightning Labs - Architect of LND, one of Lightning Network’s implementations. Taro is the company’s new protocol. It’s special, and I’m in the early days of discovering and theorizing its potential. Received a $70 million investment just weeks ago.
OpenNode - Yes, I used to write for this company! Bringing merchant adoption worldwide, including a stunningly fast LN integration with McDonalds in El Salvador. Need more background on this, and can’t wait to see what other big fish the team can hook on the merchant side. Received a $20 million investment earlier this year.
Zebedee - Pioneering a product that pushes the edges of LN’s potential, bringing streaming bitcoin to gaming. The company’s devs are heavily involved in LNurl, a way to standardize and simplify LN payments. Received an $11.5 million investment last year.
Voltage - Sponsor of The Bitcoin Layer! LN infrastructure company. Servicing clients that want more control and personalization in their interaction with LN. Node hosting. Can entrench itself as a core service provider for bitcoin companies that require LN capability. Received a $6 million investment earlier this year.
Kraken - Committed to providing LN transfers for clients months ago and delivered a product to the marketplace. An exchange demonstrating that LN capability is essential to providing bitcoin exchange services. Excited for the precedent this sets for liquidity platforms. Looking to possibly go public soon.
At age 4, Lightning Network is on the cusp of something special. And bitcoin desperately needs Lightning Network to push it ahead on the global scene. Subscribe to The Bitcoin Layer as we narrate the rise of LN and its contribution to bitcoin’s march toward world reserve currency status.
Subscribe to The Bitcoin Layer as we narrate the rise of Lightning Network and its contribution to bitcoin.
This post was sponsored by Voltage, provider of enterprise-grade Bitcoin infrastructure.