Could Lightning Network disrupt global financial technology?

One of the key promises of cryptocurrency technology is that, eventually, everyone will have the ability to stream money. Micro-payment systems have been researched since the mid 1990s, but viable solutions to process transactions of less than one dollar still elude mainstream payment companies.

The core barrier is obvious: for a micropayment to make economic sense, the transaction fee associated with it needs to be only a fraction of the size of the transaction itself. Traditional payment systems, which rely on centralized third-party servers to process transactions, are inherently incapable of processing transactions at a low enough cost to allow for micropayments.

For anyone familiar with the Bitcoin scaling debate, however, talk of near-zero transaction fees might seem bizarre. Currently, a single bitcoin transaction consumes enough electricity to power a house for a few days, and can cost more than $20 USD.

This is precisely why so-called ‘altcoins’, like Litecoin, BCash, and Dash have been doing so well recently. But even these coins, designed with fast transaction speed in mind, are orders of magnitude behind what would be required to stream money[1]. So what gives?

This is where so-called ‘second-tier’ networks, such as a lightning network, enter the picture. And while they are still very much underdevelopment, early results are showing great promise. There is a credible chance that the lightning network will become one of the most disruptive global financial technologies by the end of 2018.

Streaming money

You can think of the difference between macro and micro transactions as being like the difference between downloading a movie and streaming it online. Downloading a movie involves a bulk transfer of data, which can only be used when the full download is complete. In comparison, when you stream a movie, you can watch it as it is downloading, in real time.

Imagine that you get into a taxi-cab that charges by the kilometer. Typically, on the taxi dashboard, there will be a little meter that runs up your fare as the taxi drives. However, the taxi driver doesn’t ‘own’ this money until the trip is complete and a single bulk transaction is concluded.

With micro transactions, however, the taxi driver would receive a small payment at the completion of every kilometer (or even every meter). Most importantly, the partial payments would immediately become hers, and she could, in theory, be spending that money elsewhere even before the trip is complete.

Economics has long recognised that divisibility is a core — even definitional — attribute of currency. However, the practical value of being able to, for example, split a dollar into 100 cents, is severely mitigated when those cents cannot be individually spent over electronic payment networks.

Below are some potential implications of a payment network that allows for micro or nano transactions. Whether these changes will have positive effects or not is very much up for debate. But either way, they will soon become possible, and you should prepare for them.

1) The infamous “payday” could be completely eliminated. Employees could be paid a salary stream in real time for every second of work that they log. Besides offering a solution to the problem of convincing employees to log their time regularly, this could destroy, or at least drastically alter the multi-billion dollar payday-loan industry.

2) Content and services could similarly become entirely divisible. Online news sites that follow an on-demand model could, for example, charge customers per word that they read, rather than a monthly subscription, allowing people to purchase the service even if they only read a few paragraphs a month.

3) User-differentiation would be particularly potent in the market for “club goods”, which is to say, things that we own but aren’t always using. Airbnb has made a huge success of allowing people to rent out unused property, and there are already products available that allow you to do things like “rent out” your computer’s processing power while you aren’t using it. Micro-payment channels could greatly facilitate the transaction processes required for these types of services, allowing for smaller, faster payments during short bursts of rental.

4) Relatedly, time-variant pricing has already been shown to drastically reduce the cost of supplying goods where usage isn’t uniform over time, but rather spikes during certain hours. For example, electricity suppliers have been able to cut fixed costs, and even avoid having to build new plants, by charging lower off-peak rates, and thus encouraging people to use power when demand is low. But they are still only able to set 2 or 3 static rate changes. By using micro-payments, the cost of goods and services like electricity, water, bandwidth, airtime, ubers, web-hosting, and many others could change in real time, while they are being consumed and while payments are being processed, depending on the demand.

The Bitcoin Scaling Debate

Transactions on the bitcoin network are processed in blocks of 1 megabyte each (the ‘effective’ size is now slightly larger, after the introduction of a processing technology called SegWit). 1 block is processed roughly every 10 minutes. The increasing number of transactions on the network has lead to higher transaction processing times (up to 8 hours) and higher fees.

Many have argued that Bitcoin should increase its block size, and one group even created a new coin (Bcash) off the bitcoin network that has an 8 megabyte block size.

The problem with increasing the block size is sustainability of the solution. Currently only a very small percentage of the world population transacts with Bitcoin, and they do so on average much less than once a day. If Bitcoin was used by everyone, and people processed thousands or millions of micro transactions per day, the block size would have to increase to several terabytes to be able to handle the volume.

At this size the system becomes vulnerable to DOS attacks and the bandwidth required to run nodes escalates enormously. Only large corporations could afford the infrastructure required. As Andreas Antanopolous put it, “We could think of a name to describe these corporations. Let’s call them, I don’t know, banks”.

Of course, the whole point of Bitcoin is to remove the need for trusted third parties. If Bitcoin is to keep to this philosophy, then scaling block sizes cannot work in the long term.

The Lightning Network

The central thesis behind the idea of a lightning network is that transactions, even ones involving digital money, don’t always have to be broadcast onto a ledger. Let’s explain how this works, first by thinking about ordinary bank transactions.

Let’s say that I’m in a taxi that charges per kilometer, and I want to pay using my credit card. One way that I could do this is to log onto my banking site and EFT the driver money from my credit account at every kilometer. The bank would be made aware of these transactions, and update their ledger accordingly, and I would be charged a fee for each of the updates.

Alternatively, I could load money onto a credit card, and at the end of the trip I could simply give the driver my card and tell her the password (don’t try this at home). In this way, I will have transferred funds to the driver without the bank ever knowing, and without paying any transaction fees. In fact, payment channels are often illustrated using gift cards as an example. Gift cards can in theory be transferred millions of times with no banking fees.

However, this is still a macro transaction, because while the trip is still ongoing, the driver has no control over the funds, and has to trust that I will eventually pay him. Remember, in the Bitcoin universe, the goal is always to avoid needing to trust anyone. Therefore, the final puzzle piece that is proposed to solve this problem is the use of smart contracts.

A smart contract is a contract that will execute automatically when its condition is met (in this case, when the trip is complete). The idea is that the certainty of smart contracts can be made so solid that a third party should be willing to accept a promise of a payment from the driver even before the trip is complete, because the smart contract guarantees that the driver will, at a minimum, receive payment for the kilometers already driven.

In fact, as long as the chain remains unbroken, there is no reason why the transaction should ever have to be broadcast to the actual Bitcoin network. The smart contract can simply be novated at its termination for another term. Actual processing of the transaction is only ever required when a party tries to default on payment (which they have no incentive to do).

Some experts think that after the lightning network is implemented, people will, on average, only broadcast two transactions a year onto the Bitcoin network, thereby reducing the average transaction fee to millionths of a cent.

So where are we now? There are still dozens of problems that need to be resolved before lightning networks can enter production phase. But don’t overestimate the time required to do this. Indeed, you can test a lightning network prototype here right now if you want to (using test coins, of course). Torguard is already accepting lightning network payments with real Bitcoin, and a large competition has been started among universities to increase the speed of development.

The Potential Effect on Cryptocurrency Markets

How do we measure the value of one cryptocurrency against another? Every coin’s developers will have a host of reasons for why they think that their coin is technologically superior. However, the biggest deciding factors at the moment are clearly speed and transaction costs. If lightning networks work, however, then the difference in speed and cost of Bitcoin versus, e.g. Bcash will be vanishingly trivial in comparison to the difference achieved by the lightning network, rendering that debate moot.

At that point, what drives relative prices? Will the thousands of alternative coins all co-exist? Or will there be a winner? Many coins are made to support specific platforms, and will probably do well in those niches. But for currency-like coins, the only clear distinguishing factor then might well be network effects: i.e. the winning coin will win because it is winning.

Two things we know for certain is that cutting out transaction fees will take Bitcoin one step closer to delivering on the promise of providing a viable alternative medium of exchange to fiat, and go a long way towards addressing concerns about the energy requirements of the network.

[1] Iota is maybe an exception. But it remains to be seen whether they can get their infrastructure working properly and sustainably.

Have your say!

Do you feel the Lightning Network is the solution to Bitcoin’s scaling debate, or should scaling rather be pursued through other means – such as through larger blocks? Let us know your opinion on Twitter: @coininsidercom!

Neil du Toit is a data strategist at Q Division. In his free time, he writes interesting articles for his personal blog.

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