Free Banking for Bitcoin? How the Lightning Network Could Help

How do we scale the system for broad use?



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.