GATEWAY TO THE CRYPTO WORLD … · the Bitcoin Lightning Network. This second layer protocol, run...
Transcript of GATEWAY TO THE CRYPTO WORLD … · the Bitcoin Lightning Network. This second layer protocol, run...
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CRYPTO FINANCE AG
YOUR GATEWAY TO THE CRYPTO WORLD.
EXCELLENCE. QUALITY. INTEGRITY.
Research Paper
BITCOIN’S LIGHTNING NETWORK
& THE EMERGENCE OF INNOVATIVE BUSINESS MODELS
19 December 2018
Authors: Maximilian Boelstler (Research Assistant) and Dr Lewin Boehnke (Head of Research)
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Disruptive Technologies drive the Emergence of Innovative Business Models:
A Peer-to-Peer based Interest Rate and Savings Account without Counterparty Risk
As blockchain technology matures, the market becomes more professional and measures are taken
to eliminate its weaknesses. Bitcoin, as the most famous cryptocurrency, is often criticised for its
scalability problem, i.e. the fact that only a limited amount of transactions can be done per second. A
traditional payment solution provider such as VISA is able to process up to 56,000 transactions per
second (around 2,000 on average), whereas bitcoin is only able to process between three to around
ten transactions per second (depending on transaction type).
It is well known that necessity is the mother of invention. Consequently, an idea emerged where
transactions are conducted off-chain but retain the security standard of on-chain transactions. This is
the Bitcoin Lightning Network. This second layer protocol, run on the bitcoin blockchain, enables fast
transactions through a network of bidirectional payment channels. The network makes it possible to
process millions of transactions per second (using bitcoin as a payment method) via its second layer
protocol called Lightning. A transaction settlement can be done instantly due to the off-chain
architecture.
Does this mean that bitcoin will soon be usable as a currency?
Excepting the volatility risk, we would argue “Yes”. The Lightning Network offers incredible progress
toward the use of bitcoin as a medium of (instant) exchange. However, this is not the subject of this
article. Instead, we would like to focus on the interesting topic of the time value of bitcoin and the
Lightning Network Reference Rate (LNRR), introduced by Nik Bhatia, and the idea of establishing a
savings account without any counterparty risk and peer-to-peer based interest rate.
We will start by giving you a general overview of the Lightning Network, its payment channel structure,
and the concept of routing. After that, we will go into more depth about these two business models
and address the associated limitations. Lastly, we will then take things one step further in our next
research report. Since the possibility of determining a risk-free interest rate of bitcoin would affect the
price determination of bitcoin derivatives, we will analyse the resulting differences concerning the
recent (and the potential future pricing) of bitcoin derivatives considering the Lightning Network Rate
(LNNR).
https://medium.com/@timevalueofbtc/the-time-value-of-bitcoin-3807b91f02d2
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About the Lightning Network and its Payment Channels Structure
As already mentioned, bitcoin is often criticised for its scalability problem. The root cause for this is
also one of its highly appreciated core characteristics – the recording of every transaction on bitcoin’s
main chain. Joseph Poon and Thaddeus Dryja proposed a solution with the implementation of the
Lightning Network in early 2016, summarised in their whitepaper “The Bitcoin Lightning Network:
Scalable Off-Chain Instant Payments”.
The Lightning Network is based on a second layer protocol run by the bitcoin blockchain. The three
companies Blockstream, Acinq, and Lightning Lab are involved to the extent that they develop and
provide the lightning protocol and the associated ecosystem, e.g. with c-lightning, eClair, and lnd. In
order to solve the scalability problem, transactions are processed off-chain instead of on-chain,
meaning that transactions can be conducted without actually transferring the custody of funds. This
can be achieved by using an interchannel rebalancing mechanism, which makes the processing of
several thousands of transactions per second possible in an instant and nearly commission free.
In Fig. 1 below, you will see an illustration of the relation between bitcoin and the second layer protocol
Lightning.
Figure 1: Relation between bitcoin’s main chain and the Lightning Network
From Fig. 1, it can be derived that the Lightning Network is on the one hand independent of bitcoin’s
blockchain, but, on the other hand, it is still interacting with bitcoin’s main chain. At any time when a
payment channel is opened or closed, communication with the main chain will occur. The Lightning
Network itself consists of nodes. If payment channels are opened properly, these nodes process and
are able to route lightning transactions. The connection between two nodes is called a payment
channel, or to be more specific, a bidirectional payment channel with a hashed timelock contract.
As soon as two parties have funded a payment channel, the funds become locked via a multi-sig
contract between the corresponding parties. From an application-oriented perspective, this can be
compared with the storing of funds within a safe “off-chain”. Every channel is limited to its funding
amount, meaning that transactions routed by a channel can only be processed up to the initial funding
amount (more details on this below in “The Concept of Routing”). Additionally, multi-sig implies that
https://lightning.network/lightning-network-paper.pdfhttps://bitcoinexchangeguide.com/bitcoin-lightning-network-btc-ln-is-growing-with-460-btc-and-16000-channels-and-counting/https://en.bitcoin.it/wiki/Hashed_Timelock_Contractshttps://blog.chainside.net/understanding-payment-channels-4ab018be79d4https://blog.chainside.net/understanding-payment-channels-4ab018be79d4
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the safe can only be opened if both parties sign a transaction. As long as the funds remain in this safe,
they can be transferred instantly between the corresponding participants. After any transaction, the
two parties then update the recent state amongst themselves like an ever-shifting balance sheet. This
is somewhat akin to the decentralised concept of real time gross settlement (RTGS) and CLS
(continuous linked settlement) found in traditional banking with the significant difference that it is
trustless.
When one party submits the state back to the blockchain, the payment channel will be closed and the
latest transaction balance will be broadcasted to the blockchain – but potentially, the timelock will
need to be expired. Finally, the funds are available again on bitcoin’s main chain. Since there is no
possibility of receiving and sending more money than initially funded and locked, the entire concept
results in a zero-sum game.
The participation in or the usage of the Lightning Network is possible by either running a full lightning
node (internal node) or by using a lightweight wallet (SPV) software application to send transactions
(external node or leaf). The terms internal and external nodes stem from data structure theory.
Whereby an internal node describes a node with at least one child, a leaf is characterised by no
children. Currently, receiving of transactions is only possible by running an internal node; however, an
increasing interest in Lightning has fostered several initiatives to develop a lightweight wallet, which
will allow for the participation in Lightning without the need for a full node.
In the wake of the Lightning Network, both node forms differ also in transaction liquidity: whereby the
usage of a leaf is limited to the conducting of transactions (restricted using of the liquidity), an internal
node may function as a routing provider (liquidity provider). Due to the nature of our research, this
report focuses on the running of a full lightning node (internal node), and the possibility of earning an
interest rate for providing funds to the network.
The Concept of Routing
Apart from the payment channel structure, the Lightning Network is characterised by its routing
systematic. To send transactions through the entire network and not just to a direct peer using
established payment channels, nodes with enough liquidity in the right “funding direction” can act as
a bridge. These nodes are referred to as “routing-nodes”.
Let me explain this functionality with an example:
Cornelius would like to make a Lightning transaction with Florence to settle his debts resulting from
yesterday’s dinner. Unfortunately, the two friends have not yet opened a direct payment channel
between them. They then realise that they have an “indirect” channel via Daisy and Eric. And since
there already is a payment channel between Cornelius and Daisy, who also has a channel with Eric,
who in turn has a Lightning channel with Florence, an indirect payment channel is found. In Fig. 2
below, you can see an overview of this rather complicated constellation.
https://hackernoon.com/difference-between-sidechains-and-state-channels-2f5dfbd10707https://en.wikipedia.org/wiki/Tree_(data_structure)https://en.bitcoin.it/wiki/Lightweight_nodehttps://medium.com/coinmonks/amount-independent-payment-routing-in-lightning-networks-6409201ff5edhttps://medium.com/coinmonks/amount-independent-payment-routing-in-lightning-networks-6409201ff5edhttps://blog.lightning.engineering/posts/2018/05/30/routing.html
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Figure 2: Concept of Routing: Initial Positions
Apart from the fact that there is a payment channel connection in general, there is no information as
to “how” the single channels are currently being funded. The channel funding and the associated
channel allocation has a significant impact on the routing capability and the resulting possibility of
forwarding the transaction. In order to give an overview of some extrema, please take a second glance
at Fig. 2 above and the three different initial positions exhibited.
A payment channel can be compared with slide control. Aviv Zohar, Associate Professor at the School
of Engineering and Computer Science at The Hebrew University and The Chief Scientist at QED-it,
states that “you can think of it as if we are in a state space between 0 and 10. If we are just transacting
in single units of bitcoin, we are just moving around there”. Therefore, we tried to integrate the “funding
direction” in the overview. So, let us explain this statement more in depth and let us assume the
following channel allocations (c.f. Fig. 2):
Channel Allocation 1:
o Cornelius fully funded a channel with Daisy in the amount of 200 satoshis
o Daisy fully funded a channel with Eric in the amount of 50 satoshis
o Eric fully funded a channel with Florence in the amount of 100 satoshis
Channel Allocation 2:
o Cornelius partially funded a channel with Daisy, both in the amount of 100 satoshis
o Daisy partially funded a channel with Eric, both in the amount of 25 satoshis
o Eric partially funded a channel with Florence, both in the amount of 50 satoshis
Channel Allocation 3:
o Daisy fully funded a channel with Cornelius in the amount of 200 satoshis
o Eric fully funded a channel with Daisy in the amount of 50 satoshis
o Florence fully funded a channel with Eric in the amount of 100 satoshis
As already mentioned, if there is an indirect payment channel from Cornelius to Florence, he has the
possibility to transfer his funds using the concept of routing. Moreover, he does not face the necessity
to open (and thus fund) a new, direct payment channel because, in general, the opening of the
payment channel is associated with a transaction fee because of the associated on-chain transaction.
https://scalingbitcoin.org/transcript/stanford2017/how-to-charge-lightning
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Coming back to the channel allocation opportunities, we can derive two extrema: one-sided, fully
funded payment channels (c.f. Channel Allocation 1 and 3), and perfect equally funded channels, as
can be seen in Channel Allocation 2. In practice, every slide control position is possible.
Depending on the current state of these routing channels and the corresponding slide control
position, the following transactions (maximum gross channel amount) between them are possible:
Figure 3: Concept of Routing – Case Scenario: maximum transaction amount
At first glance, one might quickly recognise that in the case of Channel Allocation 3 exhibited in Fig. 3,
no transaction from Cornelius to Florence is possible. Since the channels are funded “in the wrong
direction”, only transactions from Florence to Cornelius could be routed. The same situation can be
actually observed in Channel Allocation 1, but with the significant difference that a transaction is
possible due to the “perfect” funding allocation for this transaction – but let us play this routing game
step by step:
Cornelius might transfer up to 200 satoshis
BUT Daisy ONLY has a routing capacity of up to 50 satoshis
Finally, Eric would be able to forward 100 satoshis
Therefore, we can draw the conclusion that a routing path cannot forward more than the smallest
channel capacity within the corresponding path. In this case, no more than 50 satoshis can be
transferred. Other paths through the network might be able to route larger payments between
Cornelius and Florence.
By considering Channel Allocation 2, one might observe the same issue with the difference that the
situation is even worse. Due to the payment channel equivalence between Daisy and Eric, she is now
only able to forward 25 satoshis.
To sum up, not only the funding amount of a payment channel, but also the channel allocation has a
considerable influence on a node’s routing abilities.
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We have neglected to mention the previously described “routing fees” so far. In exchange for routing
the payments, the payment sender, who is in this case Cornelius, must pay a fee to the routing nodes.
For the net calculation of our dinner scenario, please take a closer look at Fig. 4 below.
Figure 4: Concept of Routing – Case Scenario: maximum transaction amount, incl. routing fees
It is necessary to clarify that every node provider has the opportunity to determine its own routing
fees within its node settings. These fees are composed of a base fee rate and a proportional fee rate
(to the transaction amount). In our case scenario in Fig. 4 above, we used a base fee of 1000msat (= 1
satoshi) and a proportional fee rate of 100ppm (parts per million) = 0.01%, meaning that the sender
must pay 100 satoshis for every 1,000,000 satoshis transferred. Even though a dinner between 50 or
200 satoshis is not feasible, these are realistic fee rates, which have been recently applied in the
Lightning Network.
As soon as we take into account that Daisy and Eric charge the fees mentioned above, the maximum
transaction amount of the corresponding channel decreases by one satoshi due to the smallest
channel capacity of 50 satoshis between Eric and Daisy. Even if Cornelius transfers 52 satoshis, the
remaining two satoshis would be stuck in the channel with Daisy.
The Lightning Network Rate (LNNR) – a Peer-to-Peer based Interest Rate for Bitcoin
After having now described how the Lightning Network works, the one or other reader might already
have an idea of the possibility concerning the “technological” determination of interest rates.
Nevertheless, most readers will ask themselves how an interest rate might be determined if every
node provider could set its own fee rates. To be honest, that makes no sense, does it?
The answer is a peer-to-peer based interest rate. One property of the Lightning Network is the “free
choice” of the transaction path. Nevertheless, every default setting of a Lightning application generally
selects the cheapest path due to the routing algorithm employed. This seems quite reasonable from
https://1ml.com/node/03864ef025fde8fb587d989186ce6a4a186895ee44a926bfc370e2c366597a3f8f
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an economical point of view due to the general rule that a market chases efficiency. Therefore, the
channels, which are not in line with the fees of the great majority, will never be actively used.
The routing algorithm employed also considers influencing factors, e.g. the payment channel volume,
the possible connections, but also (as previously mentioned), the associated transaction fees. In order
to analyse which transaction paths are possible, the Light Pathfinder tool, provided by
lightningfees.net, could be used (see Fig. 5). Such tools rely on public information of the network,
where the current allocation of funds in a channel is private information between the two involved
parties. While qualitatively accurate, the precise numbers might be off.
Figure 5: Visualisation of Transaction Paths
Source: http://lightningfees.net./
Using this example, we tried to conduct a transaction from our Crypto Finance Research Node
(“CRAG”), in Fig. 6, called “Source”, to a BitMEX Research Node called “Destination”. As you can see,
there are several routing paths available for this transaction. The paths differ in transaction fees and
the number of nodes involved. In this particular case, there is either the possibility to route via one
node to four nodes.
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According to the whitepaper by Poon and Dryja, the general rule states “smaller transfers with more
intermediaries imply a higher percentage paid as Lightning Network fees to the intermediaries.” In
practise, however, every node has its own routing fee settings. Taking a second look at Fig. 5, you might
recognise the corresponding channel fees exhibited by the arrows between the channels. The number
in brackets below indicates the maximum routing amount for this corresponding channel. In our
example, a maximum of 5 million satoshis (~ USD 1771) could be transferred between CRAG and the
BitMex Research Node for a fee of 1000 satoshis (~ USD 0.035). This equals a percentage fee of
approximately 0.02%. An overview of the correlation between the transaction amount and the
corresponding transaction fees for our sample transaction can be found in Fig. 6.
As you can see, the fee chart is shaped by terraces whereby each stagger represents a different
transaction path. The different paths are marked in gold in the path visualisation above the terraces.
Since the base fee is commonly one satoshi or 1000msat, respectively, the transaction fee is mainly
due to the proportional fees of the different paths.
Using this example, one might recognise that transactions up to 1,700,000 satoshis are almost
commission free. Suddenly, the first [second] terrace emerges implying that a different channel needs
to be used for a transaction in the amount between 1,700,000 [3,000,000] satoshis to 3,000,000
[4,500,000] satoshis, whereby a higher proportional fee rate is applied. The maximum payment
amount between these two nodes is limited to 5,000,001 satoshis. Generally, the maximum payment
channel amount is limited to 16,777,215 satoshis, as defined by the current Lightning protocol
restrictions. Additionally, the chart supports the described proportional relation between transaction
amount and transaction fee.
Especially from an economical point of view, questions might be raised concerning the incentives of
providing a Lightning node. In recent times, routing fees that might be earned by providing a node
1 https://99bitcoins.com/satoshi-usd-converter/ (10.12.18)
Figure 6: Transactions fees in proportion to the Transaction Amount
Source: http://lightningfees.net./
https://lists.linuxfoundation.org/pipermail/lightning-dev/2017-December/000872.htmlhttps://99bitcoins.com/satoshi-usd-converter/
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have varied significantly. Nik Bhatia
referred in one of his articles to a Twitter
post made by Alex Bosworth sharing their
node statistics (c.f. Fig. 7). The data reveals
that Alex earns a 0.4% interest rate on his
principal amount provided, which, in turn,
is “material income” in recent times by
taking into account the interest rates
offered by banks. Controversially, Andreas
made less even though he provided a larger principal amount. This might be due to his node settings
and positioning. While technologically sound in itself, the infrastructure around lightning is very much
still evolving. How should a node choose its peers to position itself well as a route, and, subsequently,
receive relevant fees? When should a channel be closed based on the changed global situation and
reposition? Fully automated approaches, so called autopilots, are very much underperforming human
experience these days. Successful heuristics are proprietary information.
In this context, we have to mention explicitly that these stats are not representative. However, they do
hint toward the general possibility of earning an interest by providing liquidity to the Lightning
Network. This approach allows investors to measure their opportunity cost of bitcoin. The larger the
Lightning Network becomes, the more representative data will be available. Of late, the network is
based neither on rationality nor on efficiency. There are several people acting as Lightning enthusiasts
and thus providing liquidity for free, implying that they are running a node without any economic
incentive.
Ben Woosley, a developer of the Lightning wallet app Zap, stated, "As the network grows and a smaller
portion are using it for ideological reasons, fees will move toward a more economic outcome." Factors
such as node positioning, the number of channels, and their funding amount might have a significant
influence on the economic performance of a node.
From an economical perspective, the concept of routing fulfils two tasks akin to a centralised,
traditional commercial bank and the central bank: providing liquidity and determining an interest rate.
The difference is that the Lightning Network takes charge of this task in a decentralised manner. An
interesting approach emerges to determine interest rates on a peer-to-peer basis and not the
centralised determination by one or several central banks.
A Savings Account without Counterparty Risk
A savings account is an interest-bearing deposit account held at a bank or other financial institution
that provides a modest interest rate. In every traditional, interest-bearing financial product offered,
the involvement of a counterparty such as banks, insurances, or other third-party companies is
required. Even with the so-called risk-free treasuries, a counterparty risk is associated in form of state
bankruptcy.
Besides the fact that Lightning offers a risk-free interest rate for providing liquidity in form of bitcoins
to the Lightning Network, a further interesting property arises: there is no counterparty involved. In
this context, Poon and Dryja compare the concept “to a gold lease rate without custodial risk”.
Counterparty risk is the risk to each party of contract that the counterparty will not live up to its
contractual obligations. In Lightning, the funds are locked via a multi-sig contract due to hashed
Figure 7: Node Statistics
Source: https://medium.com/@timevalueofbtc/observations -from-alexbosworths-tweet-on-fees-e9b0be1fda86
Andreas' Node Alex's Node
Fees (satoshis) 4,204 7,829
Principal Amount (satoshis) 4,391,891,892 101,351,351
Fees (USD) 0.31 0.58
Principal (USD) 325,000.00 7,500.00
Annualised 0.0050% 0.4025%
https://medium.com/@timevalueofbtc/observations-from-alexbosworths-tweet-on-fees-e9b0be1fda86https://twitter.com/alexbosworth/status/1019985943321706496https://twitter.com/alexbosworth/status/1019985943321706496https://www.coindesk.com/you-can-now-get-paid-a-little-for-using-bitcoins-lightning-networkhttps://www.investopedia.com/terms/s/savingsaccount.asphttps://www.investopedia.com/terms/c/counterpartyrisk.asp
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timelock contracts (HTLCs). When this timelock is due, the latest balance will be submitted. Therefore,
the contract is enforced either when counterparties cooperatively close the payment channel or when
the timelock is due. Thus, the counterparty risk is replaced by a protocol risk due to issues associated
with the cryptographic pegging.
Starting from the Bottom, now we have around 13,000 Channels
The Lightning Network was launched in mid-January 2018. On December 10, there were around 4,000
nodes. Its current network capacity contains around 160BTCs in the amount of USD 1,700,000.
According to Jonas Schnelli, one of bitcoin’s main developers, “channel amounts will slowly increase as
confidence rises.” A recent snapshot of the Lightning Network, meaning a visualisation of the 4,000
nodes and its 13,093 payment channels, can be found in Fig. 8 below.
Therein, the single nodes
are shown as labels by their
“nicknames”. Some inter-
esting examples are
“SWIFT.connect”,
”***ROUTE 66***”, “VISA
Killer” or “RebelDinosaur
[LND]”. The colourful lines
between them represent
the opened payment
channels. On closer
inspection, one might also
identify a structure as to
how they are linked to each
other, resulting in a kind of
hub and spoke system.
Some nodes have many
payment channels and
thus act like a hub.
According to Poon and
Dryja “eventually, with
optimisations, the network
will look a lot like the
correspondent banking
network, or Tier-1 ISPs.”
This assumption is
supported by a recent
network trend: since mid-November, the network capacity has increased by around 320%. This
development is mainly due to a provider of the so-called “LNBIG.com [lnd-xx]” nodes whereby “xx”
represents a placeholder ranging from 01 to 42. In short, an unknown party provides at least 20 nodes
with channel capacities ranging from 15BTCs to 26.7BTCs (~ USD 53,204 – USD 94,655 on December
10, 2018), with an ongoing upward trend in evidence. Unfortunately, we cannot make any specific
statements about their transaction and routing volume, since the information is private.
Figure 8: Visualisation of the Lightning Network
Source: https://rompert.com/recksplorer/ (10.12.18)
https://1ml.com/
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Limitations of the Lightning Network
Although the concept of Lightning proposes a considerable approach concerning the scalability
problem and other bottlenecks associated with bitcoin, the second layer protocol still has some
limitations.
The major issues are due to the early development state of the network and the surrounding
ecosystem. Since full participation (sending and receiving of transactions) is only possibly by running
an internal node, access is more or less restricted to people having the necessary expertise to set up
and run a node. This leads to a limited number of participants and liquidity within the network.
Additionally, the Lightning Network can easily be dominated in the current state, c.f. the entrance of
LNBIG. Thus, the decentralised establishment of an interest rate is not possible and the network might
be easily centralised. Moreover, the routing systematic is not completely matured. In consideration of
Lightning’s upper limit on channel funding amounts, larger payments are most likely to fail since they
cannot be successfully routed. This leads to the fact that Lighting is currently (only) suitable for smaller
transactions.
However, optimisation measures have already been taken with the implementation of the so-called
multi-path routing for payments. This mechanism allows the splitting up of a payment in multiple
partial payments, which will be routed by all channels available that together make up the total
amount. Therefore, it becomes possible to overcome limitations of a single funding channel amount.
In conclusion, we can state that Lightning represents an effective approach to solving the scalability
problem of bitcoin. Furthermore, some interesting business models have emerged in this context.
When the network grows, it becomes more stable, and thus a representative LNNR might be
established, which influences the derivatives pricing of crypto assets. In our next research report, we
will be conducting a thought experiment, where we analyse how this interest rate could influence the
pricing of bitcoin futures.
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