While Ethereum based DeFi has stolen the show for most of 2020 – and rightly so, the amount of innovation and experimentation happening there is insane! – there have also been some major breakthroughs on Bitcoin’s native layer 2 scaling solution, the Lightning Network. I believe that this progress, while less flashy, will ultimately prove equally as important in the long run. In this post, I’ll provide an overview of these recent developments as well as a sense of the grand vision I see forming for Lightning around payments and Web3 applications.
First off, a quick reminder on what Lightning is and how it works. Lightning is a network of bi-directional payment channels that allows for instant settlement between parties and routing of payments over a TOR-like p2p network settled in units of bitcoin. You can learn more about the network’s design and technical specs here.
In contrast to DeFi’s “move fast and break things” attitude, Lightning development has been intentionally slower and more methodical. Up until late August, Lightning Labs had capped the channel capacity and payment size for users of their popular implementation of the network to ~$2000 USD and ~$500 respectively to better protect user funds with experimental software.
Despite this measured development philosophy, Lightning has still made meaningful progress over the last 2 years. While it’s impossible to tally accurate node and locked-BTC counts (the network is onion-routed and private like TOR), best guesses as of Oct ‘20 include:
- > 14,000 public nodes
- > 36,000 public channels
- > 1050 BTC capacity ( >$12M USD)
As the Lighting Layer image below shows, that’s a pretty dense network!
These numbers certainly pale in comparison to the >$1B wrapped BTC minted on Ethereum though. But the Lightning Network offers two entirely different value props that no other blockchain or smart contracts platform can match:
- Instant settlement in bitcoin with nearly 0 fees (Ethereum fees spiking to >$10/transaction during the DeFi craze of sumer 2020 was a good reminder of its own scalability limitations)
- Movement of bitcoin (including in more exotic, DeFi-style smart contracts) without any counterparty risk. All BTC<>ETH bridges boil down to “bitcoin IOUs” and thus require some degree of trust in a centralized party or group of parties
To be clear, Lightning is still in its alpha phase of development and a long way from mainstream adoption. In order to have its breakthrough moment, we need to see major improvements around user experience, capital efficiency, pathfinding, developer integrations, etc. But ultimately, I believe that the prospects of instant settlement in bitcoin without counterparty risk will prove one of the most lasting use cases in all of cryptocurrency.
Let’s now explore the major developments and ultimate use cases for the Lightning Network in two categories: A) payments/finance and B) Web3.
Use Case I: Payments and Finance
1) Generalizable Payments
If you want to feel bullish on how Lightning can be used as global payments rails, read this comprehensive essay by Nicolas Burtey of Galoy. TL;DR: The best analogue for Bitcoin itself is a global settlement layer like Fedwire (run by the Federal Reserve for interbank settlements with an average transaction size of $2 million). Lightning, meanwhile, is analogous to a mashup of all the current layer 2 payment networks including: ACH, Visa/Mastercard/Amex, ATM networks, and the messaging/interop layer, SWIFT.
Lightning is strictly better than each of the USD payment networks above, because it’s:
- Instant: all settlement on Lightning happens instantly.
- Low fee: Lightning supports any size payment all the way down to sub 1 cent micropayments, which will unleash all kinds of new internet native, global commerce and even new payment types like “streaming” – imagine paying by the second for watching a movie or accessing car insurance.
- Private: the network uses p2p onion routing (like TOR) to ensure that each hop in a network only knows the next hop and nothing more.
- Open: most importantly, Lightning is an open, permissionless network. Anyone can use it. All the other USD payment networks are walled gardens that do not natively communicate. As Chris Dixon documents in his seminal essay on Why Decentralization Matters, open networks always ultimately win.
- Free of counterparty-risk: Lightning is the only payment network to date that can settle natively in bitcoin without counterparty risk or trust in 3rd parties.
Given these key advantages, I believe that Lightning (or something like it) will ultimately eat all of the USD payment networks and create the foundation for MoIP (Money over IP).
One major player pushing forward this vision is Jack Mallers’ Strike, a simple app that allows anyone to use the Lightning Network with a USD bank account. Remarkably, Strike has reduced registration time to < 45 seconds and makes sending a payment via Lightning as easy as scanning a QR code – no need for downloading/syncing a node or even knowing what Bitcoin is.
In order to achieve such feats, Strike uses (at least initially) a trusted or custodial model that hedges any BTC risk with their own trading desks and infrastructure. While questions remain around the long-term legal feasibility of such a solution, the larger point is that the speed and cost benefits of Lightning can now be abstracted away for the end user’s benefit without any knowledge of bitcoin the asset.
Other businesses are pushing mainstream Lightning adoption for shopping. Companies like Fold (and soon V1 portfolio company Lolli) offer cashback rewards for shoppers via Lightning, a Trojan horse for many people to acquire their first bitcoin. Bitrefill makes it easy for anyone to buy gift cards and phone minutes (a big use case in emerging markets) instantly using Lightning. And perhaps most exciting of all, Square has funded its own non-profit, Square Crypto, which is currently focused on developing a Lightning Developer Kit (LDK) to make it easy for developers around the world to integrate Lightning. It’s not hard to imagine how the Lightning payment network could make it much easier for companies like Square to expand internationally.
To be clear, there are still some key design questions that must be answered for Lightning to become the world’s default payment network. The two biggest, as outlined by Paradigm’s Dan Robinson here, are 1) the free option problem that exists when Lightning bridges Bitcoin to other networks and 2) the potential to clog the network with what amounts to DDoS attacks for 1-2 days at a time. While examining these problems in-depth are beyond the scope of this paper, suffice to say that both seem eminently solvable, potentially via 3rd layer integrations with a packetized payment protocol like Interledger. But that’s a discussion for another time 😉
Building on the potential for streamable micropayments, I think that Lightning’s first killer app may well be online game payments/purchases. The market for mobile gaming is insanely large and growing quickly: >$77B in 2020 with >10% YoY growth. And >40% of that revenue is coming from in-game purchases. For major games like Fortnite, it may make sense to have their own internal game currency. But for the long tail of indie studios and game devs, it makes much more sense to accept and pay out in the most liquid, globally accepted online currency: bitcoin.
This is especially true for the millions of “gold farmers” in emerging markets who spend hours playing games like World of Warcraft because they can earn far more in game than they can in their local economies. And for these gamers, global liquidity is the most important factor in which currency they want to receive. Bitcoin is dominant on this front (especially in emerging markets on both centralized exchanges and p2p platforms like LocalBitcoins, HodlHodl, and Bisq).
I’m seeing a lot of experimentation and development on this front in the Lightning community. Game studios like Donner Labs and Satoshi’s Games are creating their own games with in-game lightning purchases and payments. Meanwhile startups like Zebedee are creating software development kits (SDKs) for the long tail of indie game developers to integrate lightning payments into their games as well.
3) Exchanges + HFTs
Lightning-based financial products will in time become the norm for both consumer and professional traders who want to execute trades that are instant, low fee, and free of counterparty risk. For the mass market, marginal savings and faster settlement hasn’t been a compelling enough proposition to justify downloading a Lightning wallet and acquiring Lightning BTC. At least not yet. P2P exchanges like HodlHodl were early adopters of Lightning, but have put the project on “hodl” while waiting for more consumer demand and technology advancements. Other products like Sparkswap, which allowed users to buy Lightning BTC via atomic swaps, faced the same challenge. My guess is that most consumers will be on-boarded to Lightning via a different use case like gaming or shopping and only once they have Lightning wallets will they use them in more traditional financial products.
But for exchanges and professional/serious amateur traders, this is a very different story. In a world where you’re moving billions of dollars every day with other exchanges and OTC desks, saving a few percentage points on fees means a lot. Exchanges like River have built out their own settlement infrastructure using Lightning from day 1 to save on these costs and other major exchanges like Bitfinex are following suit. I’ve heard that many larger exchanges are interested in similar integrations, but that it’s simply not a big enough of a pain point for them today. When they can invest the marginal engineering hour in listing a new token that drives revenue vs. saving some costs on settlement, it’s hard to justify. This could change very quickly, however, with a new bull run. Bitcoin fees reaching 2017 levels again ($>25) along with a new wave of impatient newbie traders eagerly awaiting deposit and withdrawal confirmations could easily force exchanges to prioritizing Lightning adoption. And a crop of capable companies like Suredbits and Galoy are waiting on the sidelines to help these exchanges and other mainstream financial institutions integrate quickly if/when this happens.
Meanwhile, for serious amateur traders, I’m seeing a serious uptick in interest in derivatives trading sites like LN Markets. LN Markets is a centralized exchange that allows people to trade BTC derivatives using leverage (similar to BitMex). The one difference is that they allow deposits and withdrawals as well as actual trades via Lightning. While the limits they allow today are small (for regulatory reasons), it appears that they’re finding product-market fit among traders who want to be able to instantly add collateral for margin top-offs, especially during volatile price swings like we saw in March 2020 when many traders on both Bitmex and DeFi venues were liquidated as sites went down and users were unable to add to their margin position.
What’s more, there is a whole class of professional high frequency traders – responsible for 10-40% of global equity trading volume – who care deeply about 2 things: 1) the absolute fastest settlement time possible and 2) keeping custody of their funds until settlement. If they see an arbitrage opportunity between two different trading venues, they want to be able to withdraw from one account and deposit in another as close to instantly as possible. Only a network like Lightning can ultimately satisfy their concerns. As Ryan Gentry of Lightning Labs explained to me, only the Lightning Network has zero lower bound on settlement time. Blockstream’s Liquid (a federated sidechain of many exchanges) has one minute blocktimes as a lower bound. Optimistic rollups, a popular scaling solution for Ethereum, has a several second blocktime as a lower bound. Even next-gen blockchains like Solana have some amount of network delay before a transaction is confirmed.
HFTs routinely pay millions of dollars in rent to co-locate their machines next to the New York Stock Exchange data center to get the lowest latency data possible. They’ll pay almost any cost to get even a one millionth of a second informational advantage over competitors. In the world of cryptocurrency, only payment channels like Lightning allow for that level of optimization.
As Lightning increases its capability to issue and trade synthetic Bitcoin-based assets (a subject we’ll discuss in the next section), you could imagine a world where Bitcoin and a whole world of synthetic derivatives are traded and settled in real time on top of the Lightning Network.
4) P2P Derivatives
One final financial application for the Lightning Network is the trading and settlement of p2p derivatives (e.g. synthetic stocks or futures) and prediction markets. Until today, every financial derivative product has faced a version of the oracle problem – i.e. you have to trust some 3rd party to confirm the truth of an event like the price of a stock at a certain time or the winner of an election.
A new breakthrough could solve this problem: Discreet Log Contracts (DLCs). Interestingly, DLCs were proposed by Tadge Dryja, an MIT research scientist who also co-authored the original Lightning Network whitepaper. Suredbits has a fantastic blog series on DLCs, but basically they allow two parties to make a bet and use a data feed as the arbiter of truth for the outcome without that arbiter knowing it’s involved. Crypto Garage, a division of the Japanese Internet conglomerate Digital Garage, recently released the beta app for DLC based derivatives for anyone to test.
Although this software is still in its infancy, the real breakthrough will come when it can be used on Lightning, conveying the benefit of fast, instant withdrawals/deposits to a position allowing for gradual hedging and managing delta neutral positions (e.g. creating synthetic USD) without clogging the Bitcoin blockchain and incurring base layer transaction fees while also preserving some privacy. A number of companies including Crypto Garage, Suredbits, Atomic Loans, and DEBNK are currently working on DLC implementations for Lightning.
Use Case II: Decentralized Data Network (Web 3)
While I feel reasonably confident that Lightning will find product market fit with many of the payment and financial use cases described above, I am even more excited about Lightning’s long term potential as a decentralized data network empowering all sorts of Web 3 applications. To be clear, development on this front is nowhere near as advanced and my degree of confidence that this vision comes to fruition is lower. But that won’t stop me from imagining the possibilities 🙂
The vision is simple: the Lightning Network is simply an incentivized p2p data network. In principle, you can move any kind of data on this network. In a sense, the Lightning Network could become a new Internet with 3 major improvements over our existing Internet:
- User Sovereignty: since it’s a p2p network, there’s no forced reliance on 3rd party servers for identity verification. Instead, we’ll own our own identity via LSATs.
- User privacy: as mentioned above, since Lightning is an onion routed network like Tor, it’s possible to share data with another party without any centralized server knowing the content or destination of your message.
- Metered data: every piece of data will have to include a micro-payment with it. This has the potential to solve one of the oldest public commons problems of the original Internet: completely free usage that allows for DDoS attacks. Embedded payments also make it much easier to experiment with and implement new pay-for-service business models that replace the current surveillance capitalism system that emerged around a “free” to use net.
If you’d like to explore more of these concepts in-depth, I recommend 3 resources:
- Ryan Gentry’s Toolkit for Heretical Web3 Developers
- Scarce City’s simplified ELI5 version of Ryan’s article
- Dhruv Bansal’s talk on Lightning as Bitcoin’s data layer
My best guess is that we’re at least several years away from seeing Lightning materialize as a new Internet, but with increasing tailwinds around user demands for privacy and Bitcoin’s continued dominance around security at the base layer, I am becoming increasingly bullish on this vision. Let’s now explore two concrete use cases where we’re seeing active development today: chat and identity.
The first Web3 application I’m seeing gain traction on the Lightning Network is the simplest and perhaps most fundamental: chat. LN based chat apps can offer the same user experiences as traditional chat apps like Whatsapp, Messenger, or Signal, but with a few key differences:
- Privacy: Since LN is a completely p2p onion encrypted network, only the sender and recipient of the message can ever access the data. This is a marked improvement over current approaches to private chat which hold encrypted data on 3rd party servers (Whatsapp, Signal). While I find it hard to believe that anyone would trust Facebook at this point, even non-profits like Signal run their own servers and hold data which perhaps could be decrypted in the future.
- Built-in monetization: While chat apps have garnered some of the highest valuations in the world, no one has yet figured out how to fully monetize their potential while retaining user privacy. It seems that Telegram’s best shot at monetization was a $1B nixed ICO. Since money and other data are essentially indistinguishable on the LN, I expect to see a range of new, interesting micropayment based monetization strategies. One cool example would be an app that allows celebrities to post private messages which their fans must pay a small amount to unlock. The app could then take a small % of all revenue from “paid” messages. Or imagine ordering food delivery directly from your chat app with embedded payment from which the app can again take a small cut.
I’ve seen a number of exciting experiments in this space so far. Some early open source projects include Whatsatt and Juggernaut. The most polished app I’ve seen to date is Sphinx, which already offers an experience on par with Telegram.
6) Identity Issuance
A second, more experimental area where I’m seeing a lot of activity is in the issuance of identity or Non-Fungible Tokens (NFTs) on top of the Lightning Network. NFTs are unique digital bearer assets which may include a variety of software-enabled rights. As Nick Grossman of USV spells out here, the rise of NFTs marks the transition from the Web 2.0 account-based identity model to the Web 3.0 bearer asset identity model. Accessing paywalled sites, bandwidth networks, and even apartment sharing sites will eventually be mediated not by account creation but by NFTs – (s)he who bears the assets gains the access.
There’s a long history of people trying to issue such assets on top of Bitcoin – Counterparty and Omni are two notable examples. These early attempts failed because of rising transaction fees on the Bitcoin base chain. NFT action eventually moved to Ethereum (V1 portfolio co Cryptokittes by Dapper Labs is the most notable example), but is now facing the same sort of scaling challenges faced on Bitcoin in the 2014 era. It’s become obvious that no existing blockchain can scale to handle NFT volume on the base chain, meaning that one of two outcomes is likely: either 1) a new chain will exist for just this purpose (e.g. Dapper’s Flow) or 2) NFTs will end up issued on layer 2s. My guess is that we’ll see some of both. But, as mentioned above, for assets where final ownership assurances are paramount, it’s always best to anchor back to Bitcoin’s superior security. And issuing on top of a layer 2 like Lightning seems the most likely way to achieve these guarantees.
Although there are a few interesting approaches to token issuance on top of Lightning, RGB seems to have the most traction to date. These slides offer a good idea of the project’s scope and potential applications. The underlying philosophy is that we should store as little data as possible on the actual blockchain, opting instead for client side validation of whatever arbitrary business logic someone chooses to embed within their NFT. Only asset ownership needs to be provable on the blockchain itself. In addition to better scalability, this approach also allows for much better privacy than storing app logic on a public chain.
The RGB implementation is still in its alpha phase, but has drawn strong support and funding from Bitfinex, which plans to issue Tether, the dominant stablecoin with a market cap of > $15B on top of it, when ready. A successful launch of Tether would go a long way toward giving the project legitimacy and attracting other developers to build within the ecosystem.
And while RGB is promising, there are a number of other smaller projects trying to crack identity / NFT issuance on top of Lightning as well. While I don’t know what will end up winning, I’m reasonably confident that it will soon be cheap and easy to issue a bearer identity asset directly on top of Lightning.
In this post, I outlined why the Lightning Network matters and recent developments around its two major use cases: payments/finance and Web3.
To be clear, Lightning is still in the early phases of development and has some major hurdles to overcome, such as:
- Gaining developer mindshare/network effects
- Gaining meaningful liquidity
- Overcoming design challenges that limit its scalability across chains
- Reducing capital intensity
- Improving UI/UX
But, even with these challenges, I remain extremely bullish on Lightning. And ultimately it comes down to two simple facts:
1) Lightning has by far the most mindshare of scaling options on top of Bitcoin and
2) Bitcoin remains by far the most secure and liquid blockchain in the world
If Bitcoin retains its lead in security and liquidity, then I expect to see it emerge as the final settlement layer or ultimate supreme court for all global payments and Web3 data exchange. There will be a variety of ways of tapping into Bitcoin’s finality (e.g. bridges with other chains, centralized custodians, etc.), but for applications where security and lack of counterparty risk matter most, then users will want a network that taps into Bitcoin directly without issuing any IOUs. As of today, Lightning has the best shot of emerging as that network. But, of course, we remain in the earliest innings of the cryptocurrency paradigm shift and it’s always possible that another network like Ethereum becomes the most secure base chain or that better L2 or bridge networks will emerge. No doubt, it remains an exciting time to work in crypto!
If this post resonates with you, especially if you’re an entrepreneur or developer building something with Lightning, then please reach out! What’s more, if you completely disagree and believe that all payments/Web3 activity will end up taking place on other chains, then I’d love to hear your thinking as well. 🙂