Bitcoin

Free Banking for Bitcoin? How the Lightning Network Could Help

How do we scale the system for broad use?

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Bitcoins
LAURENT CHAMUSSY/SIPA/Newscom

It's been a big few months for bitcoin, and with increased media attention and monetary valuation comes enhanced scrutiny of the technology underlying the world's first peer-to-peer digital currency. For years, an intense debate surrounding the perceived trade-offs between bitcoin's daily usability as a medium of exchange and its core value proposition as a censorship-resistant currency has ravaged the development community.

Simply put, many believed that the properties that made bitcoin a great decentralizing tool also rendered bitcoin an expensive and slow medium of exchange. Yet some exciting new developments with an above-chain project called the "Lightning network" could put many of those old fears to rest. If successful, the Lightning network (or a Lightning-like solution) could help bitcoin to more closely resemble the gold-backed banknote systems of the "free banking" era.

Bitcoin's scaling debate

Bitcoin is important because it allowed individuals to transact directly with each other without needing to rely on a trusted third party like a bank or a payment processor for the first time. This means that bitcoin transactions are "censorship-resistant," and no government or corporation or outside group can prevent a voluntary trade so long as both parties have an Internet connection and some value to exchange.

This breakthrough in peer-to-peer exchange was revolutionary, and it propelled a new wave of interest and development in distributed payment applications. Yet even in the early days, enthusiasts, including Satoshi himself, noticed a problem.

The way the bitcoin network was set up worked quite well in its infancy when only a few people used the network. But if bitcoin were ever to become a global payment system, used multiple times a day by billions of people, early adopters feared that the network could become congested. Rather than a fast and cheap payment option, bitcoin could become an expensive luxury available only to those willing to fork over high fees to miners or pay in the form of exorbitant wait times. Why bother to use a distributed payment system at all? People might as well just stick with PayPal and Bank of America rather than use a slower and more expensive, albeit decentralized, alternative.

To say that the bitcoin community had a hard time settling on a path forward would be quite an understatement.

One group of users, largely consisting of business-minded parties, favored a technological fix in the form of a "hard fork," or backwards-incompatible change, to the bitcoin protocol which would increase the "block size," like a page of transactions in the bitcoin ledger, to allow more transactions per cycle. While such a change could introduce chaos into the network, and affect decentralization and security in unknown and potentially negative ways, the "big block" bitcoin camp argued that their solution was preferable to doing nothing and risking the slow death of the network.

Another, more conservative group of users promoted patience and roundabout fixes to handle bitcoin scaling. They believed that scaling problems were not as urgent as their counterparts, and had faith in the ability of developers (indeed, many in this camp were core bitcoin developers themselves) to gradually make improvements without a dramatic and risky hard fork. Furthermore, they were not convinced that every single bitcoin transaction had to necessarily clear on the core blockchain, which was necessarily expensive to run and delicate to maintain. Rather, they agreed with bitcoin pioneer Hal Finney that other technologies could be developed to interact with the bitcoin network and handle scaling "above chain."

How the Lightning network works

The Lightning network is a decentralized network of "payment channels" that sits atop of the bitcoin blockchain. Users who download the Lightning software and connect with the network have the option of opening up payment channels with other users. These channels operate in a similar manner to the Tor network, which routes traffic in such a way that other users do not know anything about the original party to a transaction. Once a payment channel is set up, users can make as many small, instant transactions as they'd like, which are later reconciled on the main bitcoin blockchain. The result is a system that allows small, cheap, and fast transactions while maintaining the amazing security and censorship-resistance of the bitcoin blockchain.

An illustration may help. Let's say that Bob wants to buy a cup of coffee using bitcoin every morning. It doesn't really make sense for him to incur the high fees and wait time of an on-chain transaction, but as a good cypherpunk, Bob wants to stick it to the banks and governments and maintain his financial privacy. Bob decides to open a payment channel on the Lightning network and deposits 1BTC with Alice's coffee shop, Starblocks. Each day, Alice keeps a record of Bob's coffee purchases, subtracting the bits for every Blockaccino that he enjoys, until both parties are ready to reconcile the balance. Alice and Bob agree on the balance, cryptographically sign balance sheet, and broadcast it to the bitcoin network. The bitcoin network then disburses the bitcoins appropriately as a normal transaction on the blockchain.

Of course, this is a very simple illustration. It doesn't consider situations where parties disagree on balances, or how people can make payments to other without a direct payment channel, or how the "multisignature transaction functions" that underlie the system actually work. These details are worked out clearly in the Lightning network white paper, but the network is still in its very early days.

Right now, it's mostly a testnet, where people can connect and probe the network using fake bitcoins. Developers would like to work out the kinks before opening up the system to "real money" transactions. But some intrepid souls have already started to use real bitcoin transactions on the Lightning network; CoinDesk estimates that $33,000 worth of bitcoins have already been spent on the Lightning network.

Free banking for bitcoin?

Why is this so exciting? An analogy to the development of free banking is illuminating. (Finney praised the work of free market monetary economist George Selgin as an instructive model for how bitcoin could scale.) Hard metals like gold have many natural properties that make them ideal currencies: They are rare, divisible, uniform, and useful. These values made them, well, valuable, and human populations across time and space eventually converged upon them as a medium of exchange. Yet gold is also heavy and hard to secure, which made lugging your money down to the local bazaar a real hassle for traders. Eventually, banking systems emerged to alleviate the problems of security and velocity without undermining the core values that gold brought to the table.

The development of free banking was therefore a kind of "scaling solution" for gold. It allowed more people to enjoy the benefits of a strong currency without incurring the heavy costs of security for each small transaction. Yet this solution was still imperfect, as history has shown. There was still a need to trust in banks; although market forces did compel good behavior in terms of capitalization and management, it did have to stink to be one of the customers of the "wildcat banks" that bucked these trends. And by the beginning of the 20th century, the rise of central banking and government-managed currencies largely undermined the previous successes of market-driven money creation and banking.

One can think of the Lightning network as a way to effect an early phase of "free banking" for bitcoin. Bitcoin users need not clear all transactions "on chain" to enjoy the benefits of a hard digital currency, just like gold users didn't need to personally lug around huge sums of gold to engage in commerce. Rather, they can transact using the Lightning network and clear their balances on the underlying blockchain, just like people could exchange gold-backed banknotes that were later reconciled on bank balance sheets. The difference in this case is that rather than needing to rely on a bank to be a good custodian of one's funds, the Lightning network could empower people to "act as their own bank."

Fintech flop or finance of the future?

The Lightning network should be of particular interest to libertarians, who tend to value individual autonomy and monetary fidelity above all else. It provides a path forward that preserves both censorship-resistance and usability. And it does so in a restrained way that would not introduce chaos into the underlying bitcoin protocol, as a hard fork might.

While the ideas underpinning the Lightning network have been under discussion for years, the network is still in its infancy, and a lot of things could go wrong. Yet it is a good bet that some form of an above-chain bitcoin solution will come to alleviate congestion and scaling problems. 2018 is poised to be a big year for bitcoin scaling, and the Lightning network will definitely be one to watch.

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29 responses to “Free Banking for Bitcoin? How the Lightning Network Could Help

  1. Illustrations of metallic coins with articles about Bitcoin are ubiquitous. They are, good intentions* notwithstanding, misleading to those seeking conceptual understanding of the nature of cryptocurrencies.

    *”Gee, we need something to draw the reader’s eye to this text!”

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  2. You can’t have money without government, therefore, capitalism needs government, and, therefore, we are all socialists. QED.

  3. It sounds like in order for me to avoid the fees for making transactions on the main blockchain, I have to essentially store my money in a “gift card” on the Lightning network between me and the other party unless someone else has already done that and has enough money in their account for me to do a pass-through. Of course, then I have to pay a fee to go through that transaction. Tell me again why increasing the blocksize like what was done with Bitcoin Cash is a bad idea?

    1. Centralisation of a decentralised currency.

      As the block size gets bigger the ability to run nodes to validate the transactions becomes more and more resource intensive. This will lead to the entire blockchain being under the control of a few. Which in essence is no different to the centralised monetary system we have now.

      The whole idea of bitcoin is to put the monetary system in the hands of the people, a system where some joe smo like myself can run a home PC and validate the blockchain. Ensuring that the ability to game the system is almost impossible.

      While I believe that the bock size will increase eventually, the whole idea of the lightning network is to put in place systems to preemptively reduce the future pressure on the blockchain before doing so. Whether is works or not remains to be seen as it too comes with inherent flaws if bitcoin is universally adopted.

      We live in interesting times that’s for sure. I believe that a type of cryptocurrency will eventually supplant our current system within my lifetime. The exact form that takes remains to be seen. My gut tells me it will come in two forms, a fully decentralised store of value currency that is equivalent to how people view gold, and a more centralised general currency that will be used for day to day transactions but who’s value is dependant on the former decentralised one. Maybe they are Bitcoin and Bitcoin cash.

      Who knows.

      1. Sidechains open the possibility of all kinds of applications and innovations without messing with the world’s most successful crypto.

    2. No, it is more like storing it on a mini bitcoin blockchain. The smaller size of the network might make it less secure than the main Bitcoin blockchain, but you’d be temporarily so risking small amounts of Bitcoin for the benefit of lower cost transactions.

  4. Stopped reading after, ” Alice and Bob agree on the balance.”

    Agreeing is easy, disagreeing is lawyer. All the white papers in the world won’t change that.

    1. You give up too easily. The very next paragraph says

      Of course, this is a very simple illustration. It doesn’t consider situations where parties disagree on balances, …

      It’s the equivalent to “assume a spherical cow”, just a starting point.

    2. Well, using clever cryptography/mathematics the system can ensure that it is impossible for a party to be cheated/frauded. Just settle the balance on the block chain and the correct balance will be split among the two parties.

  5. “This means that bitcoin transactions are “censorship-resistant,” and no government or corporation or outside group can prevent a voluntary trade so long as both parties have an Internet connection and some value to exchange.”

    My understanding is that although transactions can’t be prevented, they can be discovered and punished after the fact since bitcoin is traceable.

    In the future, I suspect the government will want to introduce a blockchain U.S. dollar like bitcoin for that reason. Why wouldn’t they want to be able to track every purchase and sale?

    It might even help alleviate the problem of theft.

    . . . unless you buy into the idea that taxation is theft. Once they can track every transaction, the temptation to tax every transaction may become irresistible.

    Privacy and anonymity are becoming archaic. Both will soon become an anachronism.

    1. They can undo theft by (majority) consensus, like Ethereum did after ‘DAO event’.

      It means they can also commit theft by consensus.

    2. Privacy and anonymity are becoming archaic. Both will soon become an anachronism.

      Isn’t that the idea? Once you become an anachronism, people have forgotten how to interface with you and generally don’t bother.

      But, yeah, (some) people have completely lost the notions such that they feel compelled to bolt features onto privacy and anonymity in order to make them sell better (or vice versa).

    3. One of the benefits of the Lightning Network is that the transactions are done off chain potentially making the transactions extremely difficult to track.

  6. Bob decides to open a payment channel on the Lightning network and deposits 1BTC with Alice’s coffee shop, Starblocks.

    Currently 1 BTC > $10,000. The man likes his coffee!

    1. Currently 1 BTC > $10,000. The man likes his coffee!

      I just assumed it was a euphemism for prostitution.

    2. The author must live in London.

  7. gold-backed banknote systems of the “free banking” era

    *facepalm*

  8. The Lightning network is a decentralized network of “payment channels” that sits atop of the bitcoin blockchain. Users who download the Lightning software and connect with the network have the option of opening up payment channels with other users. These channels operate in a similar manner to the Tor network, which routes traffic in such a way that other users do not know anything about the original party to a transaction. Once a payment channel is set up, users can make as many small, instant transactions as they’d like, which are later reconciled on the main bitcoin blockchain. The result is a system that allows small, cheap, and fast transactions while maintaining the amazing security and censorship-resistance of the bitcoin blockchain.

    1. So, if you wondered if the coins you held currently were an asset or a currency, the answer is ‘asset’.
    2. If you need more speed, simplicity, and accessibility/availability and thought ‘Tor!’, you should be hit with a hammer.
    3. Reconciling later with the blockchain requires chargeback and/or refund capabilities which, with instantaneous and relatively ad hoc networks oriented around anonymity, is going to involve wings and prayers.

    Shadow markets and currency/asset pools are not an exceedingly new idea and I’m dubious of their ability to ‘revive’ bitcoin.

  9. I don’t pretend to be a bitcoin expert, but a couple of concrete additions:
    The scaling problem, in concrete terms, is that the the bitcoin network can only do maybe 6 transaction per second. That is very far from good; Visa can do >40,000 transactions per second. The way bitcoin works makes it difficult to improve that number in the main blockchain.
    Another problem, which the article kind of ignores, is cost; a bitcoin transaction cost has grown to ~$28, which is why almost every business that accepted bitcoin two years ago stopped. At some point someone still has to pay that cost; lightning network just lets you amortize the fee over multiple mini-transactions, or maybe Starbucks will swallow the transaction cost if you hand them enough bitcoin up front.

    1. Those are precisely the two points that the article does address.

      1. I did not say the article did not address the scaling problem. I politely implied it could have addressed better.

        As for the cost, the article mentions it in passing a couple of times. If you think a couple of vague references to cost are precisely addressing it, then I think you are using rather idiosyncratic definitions of those words. If the article wanted to precisely address the cost issue, it would have addressed precisely who would be most likely to swallow the eventual costs for merging the transactions into the blockchain. Or at least mentioned the easily found cost of a bitcoin transaction (~$28) and how that might be economically amortized over multiple lightning network transactions.

  10. The lightning network currently envisioned is just to reduce transaction costs by decreasing burden on the main Bitcoin network. This is analogous to bank clearing houses.

    Free bank note issue solved a different problem. It solved the problem of maintaining price stability through periods of varying money demand. It did this by signaling banks to decrease reserves when note demand rose, and vice versa. The effect was to vary the amount of broad money available for a fixed amount of base money, to ensure price changes reflected scarcity of good and services rather than scarcity of money.

    For Bitcoin to accomplish this, a new money must be placed atop it, either as redeemable debt (as with banking), or perhaps with reservoirs of altcurrencies maintained to virtually ensure the possibility of any later on demand redemption for Bitcoin.

    For Bitcoin to ever become a money in a modern economy, it must solve both problems.

  11. Solutions to scaling are forth coming. The bigger problem is proof of work. It currently takes about a flux capacitor’s worth of electricity to unlock a block. That’s just no way to run a wealth transfer system.

  12. The IMF is considering using crytocurrency as a reserve currency. This move will sink U.S. Treasuries and cause much turmoil in the bond and stock markets. Government interest payments will explode and spending will implode. And of coarse Trump will be blamed.

  13. Bitcoin is a fail. Crypto in general as a transaction system could have a huge future, but the particulars of Bitcoin doom it IMO. There needs to be trillions of coins available to ever scale and retain a “real” value that is comprehensible to a human mind. $3.50 is a lot easier to comprehend than .00035 or whatever. Speed needs to be near instant. Fees need to be next to nothing, would could be achieved by having a huge potential number of coins to issue to those doing transactions. If you structured it right the issuance of new coins to miners could almost perfectly correlate with the number of transactions to keep the “real” value very consistent.

    Problem is most Crypto coins have been worked on MOSTLY by programmers with no understanding of monetary policy/theory etc. I, or many others, could design a system that worked far better, but a million have come and gone nowhere, and trying to break a new one now would be neigh impossible I think.

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