The Federal Reserve recently published a working paper which has some interesting takes on Bitcoin’s Lightning Network.
The paper, titled “The Lightning Network: Turning Bitcoin into Money” was written by Bank of Cleveland researchers Anantha Divakaruni and Peter Zimmerman. Lightning Network (LN) is a secondary layer network that links in with the Bitcoin blockchain. It facilitates off-chain transactions at scale.
How Lightning Network works
LN is based on smart contracts that create off-chain payment channels between two parties. The best analogy is to consider opening a tab at a bar. You give your credit card to the bartender and start ordering drinks. You continue ordering drinks over the course of the night but the bartender doesn’t charge your card until the end of the night.
So LN works similarly. One person deposits money into a payment channel. The money is spent over multiple transactions with a record kept locally. Eventually, the channel is closed out and the final status is written to the blockchain.
One of the main findings in the working paper is an acknowledgement that LN adoption has helped to improve the efficiency of the Bitcoin main-net while making Bitcoin scale and function better as a means of payment.
Technological constraints mean that the Bitcoin blockchain alone is only capable of achieving seven transactions per second.
Given that Visa processes around 1,700 transactions per second, limited throughput makes it impossible for Bitcoin to act as a payments network at scale. However, through the use of LN, it’s possible to achieve throughput of an estimated 1,000,000 transactions per second.
So while LN appears to be taking on the role of everyday Bitcoin payments, the Bank’s research states that this in turn has reduced congestion and mining fees on the Bitcoin blockchain itself.
One of the main points of debate in the crypto space surrounding LN is the claim that it is centralized. On that basis, some people maintain that it defeats the whole purpose of Bitcoin and decentralized technology.
The first thing to bear in mind is that there is no such thing as perfect decentralization. It’s more a question of the extent of the trade-offs implicated with various decentralized technologies. Previous research had found that the network was becoming increasingly centralized.
In its research the Fed has not determined if network centralization is increasing but it did find that there was limited evidence that greater centralization is associated with lower fees.
The working paper suggests that LN adoption may mean lower barriers to arbitrage across cryptocurrency exchanges as a result of lower blockchain congestion.
Efficient price arbitrage between Bitcoin platforms has been cited repeatedly by the Securities and Exchange Commission (SEC) in rejecting Bitcoin exchange traded fund (ETF) applications. On that basis, it’s a positive development if LN is increasingly playing a part in smoothing out any pricing differentials between exchanges.
Lightning support in Exodus
This content is for informational purposes only and is not investment advice. You should consult a qualified licensed advisor before engaging in any transaction.