Lightning as a retail payment system
By: Nicolas Burtey
Tags: Banking, Lightning Network, Payment Processing, Bitcoin, Fintech

Retail payment uses Layer 2

In brief, “Layer 1” or “Base Layer” payment protocols do not scale. With Fedwire, this stems from a complex regulatory framework. In the case of Bitcoin, the inability of the base layer to scale stems from a technical⁴ constraint: the block size limit.

These scaling limitations in the base layer do not prevent massive real-world adoption of these protocols. Even with the USD as the most commonly used currency worldwide, having Layer 1 limitations are manageable, so long as the Layer 2 solutions provide the scalability required.

Who currently interacts with Layer 1 for USD (e.g., Fedwire)? Banks. Companies. Governments. And, very infrequently, individuals. This correlates with the average transaction size on Fedwire, which is above $2 million.

Given these dynamics, consumers do not directly rely on the Layer 1 protocol for daily payments. They use Layer 2 solutions.

In the world of USD banking, this dynamic is easy to observe. Consumers do not have an account at Fedwire. Instead, they have an account at a commercial bank. This commercial bank account serves as a custodial wallet, at least for daily transactions.

If we apply the framework of the digital dollar to BTC, where does it lead us?

As the usage of the protocol takes off, fees on Layer 1 increase. To the point where the majority of retail consumers would not want to transact on it.

Let’s assume on-chain fees on the Bitcoin Base Layer are $100/transaction. In this instance, it will be impractically expensive for most consumers to individually manage a well-connected Lightning node with a dozen channels.

By way of contrast, let’s imagine a regional commercial bank managing a Lightning node. If we assume this bank is managing money for 10,000 people, then $100 per on-chain transaction is bearable: in aggregate, maintaining those channels will cost a penny per customer.

In much the same way retailers use Visa and ACH for daily dollar payments, they will soon use Lightning in a world where BTC adoption is taking off.

USD has a lot of Layer 2 Networks

There are dozens of Layer 2 networks enabling dollar transactions in the United States, and hundreds of different payment networks worldwide.

All of these payment networks are walled gardens. Each of them targets a specific use case. They are not extensible and evolve very slowly. Key considerations and feature include:

Fee Structures: Because these networks are walled gardens, fee structures often incentive a multi-year lock up. For a bank, it is not worth the cost of initial implementation and integration, unless they plan to access the network for an extended period of time.

Because these networks are walled gardens, fee structures often incentive a multi-year lock up. For a bank, it is not worth the cost of initial implementation and integration, unless they plan to access the network for an extended period of time. Incompatibility: There is no compatibility between these various payment networks. Let’s take the credit card industry as an example. Mastercard is not compatible with Visa. Which is not compatible with American Express. All of these networks may use some version of the ISO8583 protocol (which is analogous to a binary XML). However, these card network operators do not necessarily agree on similar tags to use in classifying and identifying transactions.

There is no compatibility between these various payment networks. Let’s take the credit card industry as an example. Mastercard is not compatible with Visa. Which is not compatible with American Express. All of these networks may use some version of the ISO8583 protocol (which is analogous to a binary XML). However, these card network operators do not necessarily agree on similar tags to use in classifying and identifying transactions. Legacy Issues: The reason we have so many payment networks is also historic. In the early days of ATM deployments, each US State or Region had its own network. We can see this evidenced through legacy brands such as Star, Plus, Maestro, and Cirrus. Each of these local, independent networks are still being widely maintained today — even as brands like Visa and Mastercard have become predominant.

The reason we have so many payment networks is also historic. In the early days of ATM deployments, each US State or Region had its own network. We can see this evidenced through legacy brands such as Star, Plus, Maestro, and Cirrus. Each of these local, independent networks are still being widely maintained today — even as brands like Visa and Mastercard have become predominant. Counterparty risk: Some networks, such as CHIPS, require accounts to be pre-funded (similarly to Lightning). As a result, they are less subject to counterparty risk compared to other networks that must have trust in the other party. Many networks mitigate this issue with a clearinghouse, which shifts the counterparty risk to the network operator.

Have you wondered why ATM fees have risen to be typically between $3 and $5 per transaction, simply to obtain cash? All of those independent ATM networks need to be maintained. It costs a lot of dollars to do such.

List of networks an ATM might be connected to.

The US dollar payment network industry is quite robust. It began flourishing in the 1950’s and 1960’s. That said, there remains a tremendous amount of fragmentation and friction in this long-standing, mature industry.

Whether a consumer is using a credit card, accessing an ATM, or completing a wire transfer, there is always a cost involved going to the network operator and different third parties. And there is typically little-to-no competition on the fees. In fact, in the case of the card networks, there was a competition… to increase interchange fees!

By way of contrast, we now have a wholly new alternative available. An Internet-based network that provides true Money over IP (MOIP), with a virtually instantaneous settlement and near-zero cost per transaction. Irrespective of the value of the transaction itself. This is the Bitcoin Protocol (Layer 1), in concert with Lightning (Layer 2). Today, in the year 2020, virtually anyone worldwide can take part in this network.

Lightning is being developed in an open environment, relying on open-source code. Given this, there are already thousands of developers experimenting with this exciting new technology. Unlike closed garden networks, compounding innovation will contribute to the general network effect of lightning.

Comparison with the early days of the Internet

We like to compare payment networks today with information networks 25 years ago. This video with Bill Gates is a helpful reminder of the state of the Internet in the 90s. No one will challenge the fact that the Internet has prevailed today. But it was certainly a contrarian view in 1995!

The Internet has succeeded over the alternative — “secured” private Intranets and AOL-style closed information networks. Why did the Internet “win” over closed networks? Because it is open to anyone.

During the past 25 years, millions of developers have made contributions to make the Internet better. By launching new products. By making the underlying protocols more scalable and secure. This compounding effect of innovation leading to the success of the Internet was simply not possible on private networks, where the layers of corporate and government bureaucracy limit innovation.

We witnessed a massive consolidation effect from many intranets and private networks to virtually every application running on the public Internet. A similar consolidation will soon happen with payment systems.

This system is so balkanized, financial institutions need, on top of those payment networks, a paid messaging system (SWIFT) — simply to be able to allow these disparate networks to be able to “talk” to each other!

This begs a question: does it make sense for a bank to run dozens of payment networks?

How long will the existing walled-garden payment networks subsist? Particularly when there are hundreds of such networks worldwide, each incompatible between the other? This system is so balkanized, financial institutions need, on top of those payment networks, a paid messaging system (SWIFT) — simply to be able to allow these disparate networks to be able to “talk” to each other!

Fun fact: Visa (a $420B company) still relies on mainframe computers, and a messaging system with a standard defined in the eighties! (ISO8583:1987). Because so few developers really know about this standard, there is a huge cost to access the network. This is a fact that Visa is monetizing, and payment companies like Stripe use as an edge.

Compare this to lnd or c-lightning using REST api and GRPC. Millions of developers know how to interact with these endpoints instantly. Additionally, the code is free and open-source, so no approval from a bank or network provider is needed to create a proof of concept or even launch a product.

The adoption of lightning will soon grow rapidly. We can envision this growth by highlighting just one company: Square. The company has been a vocal proponent of both Bitcoin and Lightning.

What do you believe will happen when Square enables their millions of merchant terminals to accept Lightning payments? Jack, the CEO of Square (and Twitter), has been vocal saying this is not a question of if, but a question of when.

Which paradigm will thrive over the long-term — closed payment networks, or open payment networks?

Bitcoin is an open settlement network. Lightning is a low cost, instant open payment network. We believe it is a given that massive consolidation will take place during the next 10 years… with 10x the pace of innovation.

Current metrics

How does Lightning currently compare with existing fiat payment systems or even Bitcoin?

Let’s first look at how the Layer 2 system like ACH and Visa compared to Fedwire and Bitcoin.

Annual transactional volume between Bitcoin, Fedwire, Visa, ACH. Y-axis is logarithmic.

We see that ACH has about two orders of magnitude more transactions than Fedwire. Visa has about three orders of magnitude more.

Where does Lightning fit into this picture?

Privacy is at the root of Lightning which is a requirement for a retail payment network to succeed.

It probably has a lower transaction volume than Bitcoin does thus far.

Bitcoin has been running for about 11 years now and has reached a state of maturity and stability that is actually backing up its value.

Comparatively, Lightning is much more nascent. While the white paper was released in 2016, the first alpha version was only deployed to mainnet about two years ago. Two Bitcoin soft forks had to happen before Lightning transactions were possible: the addition of CSV and CLTV.

Lightning is now at a “beta” stage. But it is progressing very rapidly.

Yet, what is even more insightful, is the fact that nobody knows what the lightning throughput is. And this is a feature, not a bug! The only metrics a lightning node can know for sure is:

The value of payments the node is sending and receiving

The value of payments being routed through to other nodes

Privacy is at the root of Lightning which is a requirement for a retail payment network to succeed. It builds on Bitcoin which does not optimize for privacy⁵ but transparency and robustness.

Although it is not top-of-mind for average citizens just yet, it is likely that people will become increasingly concerned with both companies and governments surveilling their everyday financial transactions. We think the option of a digital alternative that offers a good UX will help.

This means that, at some point, lightning could surpass the throughput of Bitcoin, ACH and Visa combined — without data nerds being able to notice it!

Does the price of BTC need to become stable, before Lightning adoption can take off?

It doesn’t. It is possible to use Lightning solely as a means of payment. Irrespective of whether the price of Bitcoin is stable or volatile.

Lightning is ready to be used as a means of payment. Today.

Lightning can succeed, even if people do not necessarily view BTC as a proper store of value. Why is this so? There are several reasons:

Lightning is instant

There are many derivatives readily available for Bitcoin

Lightning offers more competitive fees than transactions on the Bitcoin base layer

In other words, Lightning is ready to be used as a means of payment. Today.

When transacting with BTC at the base layer, it is more difficult to hedge efficiently than it is for Lightning. This is because transactions on the base layer can take anywhere from 10 minutes to 1 hour (or more) before they can be considered to be confirmed.

From Rene Pickhardt Twitter feed. How long can it take to confirm the next block? Sometimes more than an hour.

In a similar vein, exchanges often require 3–6 blocks of confirmations, before allowing clients to trade newly deposited bitcoin on their platform. In a market that trades 24x7, and where the market can move at any time, minutes of extra delay can have a material impact.

Lastly, the higher fees associated with on-chain BTC transactions create a natural incentive to only conduct higher value transactions on the base layer.

Compared to Lightning, it is harder to use Bitcoin solely as a means of payment. This stems largely from latency issues and fee structures. All of which make it difficult to hedge bitcoin dynamically.

For instance, a bank might be waiting for a payment worth $10m in BTC, and wants to hedge against the price fluctuations of BTC.

If the bank sells a short $10m worth of BTC on a future market such as the CME, there are a number of issues to consider. First, there is a risk of slippage, because there is a large monetary value involved. Additionally, if the BTC price is going up, but the transaction did not go through⁶, then the short position will have a negative P&L. There would be no opposite position to offset the loss.

For the bank, it is possible to see that the UTXO has been sent. However, because it is not known when a UTXO will be confirmed, it is harder to hedge.

Paying higher fees to make sure the transition will be included in the next block helps. But a race to higher fees is not beneficial for a payment protocol targeted to individual consumers.

With Lightning, it’s a lot easier to properly manage a delta-neutral position.

First, because instead of receiving large payments, Lightning incentivizes small payments. And as those small payments can sum up to large payments, because the large payment would be divided into small payments, it’s easy to gradually hedge the position, with little to no slippage.

Second, unlike with Bitcoin, when a Lightning node receives a payment⁷, the transaction is immediately settled. There is no inherent timing variability on when a transaction settles⁸.

Non-custodial lightning is not for the unbanked/underbanked

Let’s play out a thought exercise. Assume that Bitcoin is taking off, and has an equivalent role as the Fedwire for USD. In this instance, being able to interact with Layer 1 Bitcoin, and therefore Lightning, as an individual, will be reserved for a limited group of people. This might be a contrarian view for hard-core Bitcoiners. But we believe it is the most likely outcome.

In this scenario, transacting at Layer 1 would become costly over time. Even if this cost may not be prohibitive for many US citizens, it would be for most people in developing countries. We can assume that having just a dozen lightning channels open will cost hundreds or thousands of dollars per year at some point.

Despite the anticipated Layer 1 costs and restrictions, access to an open, global network would still benefit individuals tremendously, especially the ones in developing countries.

Because a bank will provide financial services for many users, their ability to offer an economy of scale in managing liquidity efficiently will make this option appealing for most individuals. Most would prefer to interact with a bank they know and have features like social recovery if they forget their passwords, or provide a lending and borrowing offering within their community.

Peter McCormack has done an interview that highlights the use of a custodial wallet over non-custodial in El Salvador with BlueWallet and Wallet of Satoshi. In a country where the average salary is $250/month, the cost of an on-chain transaction is too high, even now, in a low fee environment

Open Node data also shows that Blue Wallet and Wallet of Satoshi, the two easiest to use lightning custodial (non-regulated) wallets are currently the top lightning wallet destinations for Lightning payment.

As, in all likelihood, the cost of participating in Lightning will still be an order of magnitude less expensive than the traditional banking system, even as Layer 1 Bitcoin costs continue to increase. Lightning and Bitcoin are leveling the playing field. We believe the centralization that has happened in the banking industry⁹ could reverse. Union banks would not be as much as a disadvantage compared to big banks if they could just as easily be part of this network. A group of friends, a small village, or a community could create their own bank. This is a model of a modern Union Bank.

At this time, it is technically difficult to deploy a Lightning node that can act as a bank for a community. Even with Blue Wallet open-source LnbHub as a multi-user backend, the features set is still lacking compared to what a typical bank would provide to its customers. But we expect this open-source infrastructure to blossom in the upcoming years.

From Union Bank in emerging markets to Amazon

The massive benefits will not be exclusive to developing nations. As an example, let’s turn our attention to Amazon. Per the most recently filed 10K, Amazon had $280B in sales during 2019. Although this is not disclosed, it’s fair to assume that the majority of payments were handled via debit or credit cards. With 2%+ of interchange for every payment processed by card on its platform, Amazon incurred multiple billions of dollars of fees, simply to accept payment from customers.

Imagine an innovative, new payment solution. One as international as the Internet itself. And with a fraction of the fees of debit or credit cards. This new solution would certainly become of interest to all merchants — from Amazon all the way down to your local coffee shop.

This innovative new system will consequently enable novel participants in the network to earn fees, in exchange for providing valuable services.

The text above highlights solely the cost benefits associated with this new system: Lightning. However, the network affords many additional benefits that we have not even touched upon — from privacy and censorship resistance to finality of financial settlement on the Base Layer in minutes, not days. Novel participants in this new network will capture massive value for providing services beyond simple fees for processing transactions.