A Look At The Lightning Network

Lightnings during summer storm at night

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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, but also takes a broad look at the history of trade-offs in the cryptocurrency space as well to see why a layered approach makes the most sense.

The primary goal of this article is to examine the topic of 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, which is a small but fast-growing payments layer that is interwoven into the Bitcoin network.

Arcane Research

Arcane Research, State of the Lightning Network Volume II

Here are the sections of this article:

  • Summary Points
  • Store of Value vs Medium of Exchange
  • Bitcoin and Lightning: Scaling in Layers
  • How the Lightning Network Works
  • Lightning Network Critiques
  • Concluding Thoughts

Summary Points

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 (V), 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 existence 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.

Store of Value vs Medium of Exchange

Humans in tiny groups don’t need money; they can organize resources among themselves manually, and credit between known individuals is easy to keep track of.

However, groups that reach the Dunbar number or larger usually start identifying and making use of 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 a new money get adopted by users? I catalogued 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 together indefinitely. Precious metals, and 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 a number of 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.

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, and thus had to be abstracted with pegs, claims, and counterparty risk. Due to this speed mismatch and subsequent abstraction, policymakers managed to drop precious metals away from the process altogether, other than keeping them as opaque sovereign reserves, and were able to create a ledger-only system around the entire 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, but 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 over time, and will end up undergoing some type of 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 US and I expect it to continue both here and elsewhere in the world:

Fiat Instability

St. Louis Fed

And when we look globally, there are dozens of countries with current or recent inflation rates…

Read More: A Look At The Lightning Network

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