Envisioning LSPs in the Lightning Economy
By: Roy Sheinfeld
Tags: Lightning Economy, Lsp, Bitcoin, Lightning Network

Because Lightning is still so new and it’s still changing so fast, nobody has really cracked the formula yet. Nobody knows the best business model for LSPs. Indeed, there might be several viable, scalable business models for different kinds of LSPs servicing different niche markets. We’re just surveying what’s currently possible, concretizing our vision of the coming Lightning economy, and interpolating between the two.

Today’s LSPs are on the cutting edge. We’re the early adopters, the first movers, the cool kids on the Lightning network. Since we’re committed to — and certain of — the coming Lightning economy, the time, effort, and coin we’re spending on building the network and our user base now is an investment in our future. The future is our incentive, and progress is our reward.

Speaking of the future…

The second wave of LSPs

As the Lightning network and the Lightning economy grow, the LSP model will become more attractive. Indeed, for some current market actors, expanding their businesses into Lightning services will be a requirement for survival. A couple of existing business models will feel pressure to become LSPs in the next, say, one to three years. First are the exchanges. Second are existing payment apps, like Square’s Cash App and Venmo.

Think about it: as the Lightning economy grows, bitcoin will gradually suck fiat out of the economy, and exchanging currencies is what exchanges do. Ergo “exchanges.” Existing bitcoin users are already familiar with exchanges, and many incoming fiat users will have to pass through an exchange before joining the Lightning economy. (Unless, of course, their LSP offers a handy, in-app means to top-up their balances.)

Occupying the conduit between crypto and fiat, the exchanges won’t be able to miss the flow towards Lightning. And not expanding their services to take advantage of that position would be ludicrous.

In fact, as bitcoin expands to become the default medium of exchange with Lightning as its medium, exchanges are going to face a very busy transition period, after which, however, they’re going to need a new business model. In the absence of fiat, there won’t be as much left to exchange. Expanding their offerings to include LSP services would be a natural, rational way to master the transition.

Further, running an exchange is also a capital-intensive undertaking. They need to have bitcoin on hand anyway, but bitcoin doesn’t accrue interest. Now, if the exchanges could put some of that bitcoin into funding users’ channels, they could even make some money on the bitcoin that would otherwise just be sitting around collecting digital dust.

The proof of exchanges’ interest in the LSP model is in the fact that a couple of them are already doing it. Sparkswap and Olympus let users purchase bitcoin with USD, so they’re exchanges. But they also open channels for users, like LSPs. Sparkswap opens users’ channels immediately (just like Breez), and Olympus opens the channel when the user buys bitcoin through a Turbo channel. They’re effectively exchanges that offer Lightning services as well.

As for the payment apps, integrating Lightning as the preferred means of transferring everyday quantities of bitcoin is a natural progression from their existing businesses. Cash App already facilitates bitcoin transfers (well, sort of, because it’s custodial, so it’s not really bitcoin, is it?). Lightning is simply a better way to do what they’re already doing.

The evolving LSP business model

When the exchanges enter the LSP space, we can expect more attention and more entrants to join the party. We’re all used to bandwagons by now, right? But that’s a good thing because it means that more people will start experimenting with more different kinds of LSP models. Some might be very large and serve hundreds of thousands of users; others might be very small and might only service a few dozen friends. The LSP model scales in both directions, up and down, which is great for decentralization.

The Lightning economy needs many people to help cultivate it, and decentralization has always been in bitcoin’s DNA, so this trend is good for all of us and good for bitcoin.

At this stage, growth (read: onboarding) is the name of the game. A number of business models are thinkable for LSPs with sufficient capital. Each has to balance cost with scalability, onboarding with revenue.

If everyone jumps on the same bandwagon, it’s a revolution. (Costumes optional) (Source: Wikimedia)

Freemium models

Now, if a firm is entering an existing but very promising space with incumbent, pioneering competitors, it’ll need to catch up with and then surpass that competition. It has to grow faster than the existing providers, just like Spotify, Medium, Dropbox, and Skype have done in their respective markets. They started with good, competitive products, and gave them away — at least their basic functions or in some limited quantity.

The LSP business also lends itself to such freemium models. Since Lightning allows for transaction fees, a “free” service would effectively run on a pay-as-you-go basis, charging users transaction fees that are high enough to cover their costs. Limits on, say, channel capacities would also help contain the LSPs’ costs and provide users with an incentive to upgrade.

Such free user plans would be great for private users who want to experiment with Lightning before committing to a paid plan or for users who require limited capacity and a low-cost service (e.g. students). However, other classes of users, like businesses, will need better service, optimal reliability, more flexible capacity, and they’ll also be willing to pay for it.

In order to serve clients who need enterprise-grade performance, there will also be a market for paid, premium LSPs. Premium services could include higher channel capacities, higher transaction volumes, lower fees, SLA-guaranteed provision quality, and so on in exchange for a flat monthly fee.

Upselling

We’ve all seen those ads for phones that only cost $1. It’s also the case that you can usually buy bananas in grocery stores in the northern hemisphere for less than the cost of shipping them thousands of kilometers. These providers can lose money on phones and bananas because they make far more on the mobile contracts and laundry detergent they sell to those same customers.

Perhaps counterintuitively, such loss leaders can be rational and profitable because they attract customers to associated products or services with higher margins.

An in-app marketplace in practice. More revenue streams = faster growth = accelerating progress.

LSPs could pursue a similar strategy by offering some services for free, like opening and funding channels, as long as users commit to using other services, like exchanging, for a price. If the margin on the profitable services and the user volume are sufficiently large, the LSPs can afford to offer some services for free. Indeed, they might even have an incentive to do so at scale.

Having users’ attention when they’re paying and making transactions is also a valuable commodity in itself. There is no reason why LSPs have to restrict their business models to their own services. They can also sell products and third-party services. More specifically, why not let users purchase directly from an in-app marketplace? Doing so requires another button in the app and perhaps a few B2B partnerships, but LSPs are working on that kind of thing anyway.

Additional revenue streams, like in-app marketplaces, also help to increase customer lifetime value (CLV). That’s an important consideration, since services like opening funded channels increase the customer acquisition cost (CAC) — at least in the very short term. What matters, though, is the overall CAC:CLV ratio, so raising the CAC is not a bad thing if doing so raises the CLV even higher.

LSPs in a maturing Lightning economy

Once the second wave has hit, we can expect “LSP” and “the Lightning economy” to be household terms, even if many people aren’t entirely sure how they work — much like bitcoin now. At that point, the banks will be sweating because the entire economy will be excising the middlemen. So who would be the next entrants into the LSP market? Who would stand to gain from widespread disintermediation?

In a word: everyone. It’s hard to estimate what the banking system costs the world, but a decent first estimate is to add up the value of all the world’s banks. They’ve been able to amass around $124 trillion in assets, a number that grows somewhere around 10% per year. That’s the size of the pie that stands to be recut. And LSPs are the knives.

Mmmm. Slicing the pie. Is this the first pastry analogy we’ve used? No. Is it possible that I have a thing for sweet, delicious pastries? Maybe. (Source: skeez)

That pie is big enough for everyone to have a slice, so the LSP market is sure to flourish. The range of small-scale LSPs is likely to expand rapidly, but they won’t be the only ones.

Other things being equal, those companies with the greatest transaction volumes — excluding banks — will be the ones with the greatest incentive to foster the Lightning economy. Those with vast user bases will also have an advantage in entering the LSP market. So which businesses have vast user bases and process vast quantities of transactions? The FAANG crew (possibly without Facebook, pending the fate of Libra) come to mind, and they are likely to join the third wave of LSPs.

Third-wave business models

The image in the crystal ball gets fuzzier the farther forward we look. Business models might be as diverse as the scales of the actors providing LSP services. Small LSPs might rely on personal contacts and low overheads, like a corner barber shop. Medium-sized ones might rely on custom localizations and brand tie-ins, like many current franchise operations. The largest have vast opportunities to onboard their current users while cutting costs and expanding their revenue streams.

To imagine a big tech player entering the LSP business, consider a company like Netflix. In 2018, Netflix had around 140 million subscribers, and their gross sales were around $18 billion. Imagine the number of transactions involved and the magnitude of transaction fees they had to remit to banks. If Netflix wanted to set up an LSP, they could pay for the R&D out of petty cash, and they could maybe save a few hundred million per year by disintermediating all those payments. Considering what banks currently make, a company like Netflix could soon be generating more revenue from a growing FinTech arm than they do from their traditional video-on-demand business.

In the third wave, scale will remain important, as always. But the key is always to find the right solution for the niche. Some people prefer processed cheese from a factory; others prefer artisanal Chesires ripened strictly in the cold months. We’re eager to see where the Lightning economy goes, and we’re excited to be growing along with it.