Are Bitcoin Lightning Nodes Money Transmitters?
One of the most frustrating things to me is seeing regulators of traditional financial institutions try to force old ways of thinking into new areas. This is especially evident with issues such as the Travel Rule, which can work with traditional wire transfers but quickly gets messy in the context of crypto.
Below I try to make sense of it all.
Disclaimer: None of this is legal or financial advice. This information is provided for general informational purposes only and is not intended to be a substitute for professional financial or legal advice. Always seek the advice of a qualified legal professional. I’m just a guy trying to make sense of nonsense.
Lightning Network Basics
In order to understand potential risks and regulatory impact, it is important to distinguish between the various parts of the lightning network. Some parts are analogous to traditional finance, while others are not. For a deeper dive, see Mastering the Lightning Network, also available via open source here. (Don’t you just love the community’s commitment to making things Free and Open Source?)
Before we dive in, it’s helpful to go over some definitions.
Definitions
Generally, a Lightning Node is a computer that participates in the Lightning Network (LN). For purposes of this discussion, the following terms can be used to distinguish the various functions of LN Nodes:
Sending Node: the node which initiates the transfer of funds to the Receiving Node.
Receiving Node: the node which ultimately takes possession of the funds.
Routing Node: a node which is used to route payments from the Sending Node to the Receiving Node. A Routing Node has the following properties:
- Responsible for moving data from one node to the next, typically for a tiny fee
- Does not see the full payment route
- Unaware of which node is the Sending Node and which is the Receiving Node
- Knows the node immediately prior and immediately after
- Does not control or take custody of the funds at any point
Payment Channel: a connection between two nodes that allows the transfer of funds between them.
Money Transmission: Custody vs Routing
Lightning Network nodes can serve many purposes; however, for purposes of regulatory oversight there are two relevant functions. The first is to hold funds and use the node to send or receive payments on the network. The second function is routing payments on behalf of other nodes in return for a small network fee. These two use cases should be viewed as distinct functions, as they each likely have vastly different regulatory requirements.
If a node is custodying funds and sending/receiving on behalf of a customer, it is by definition engaging in money transmitter activity. Importantly, if an entity uses its LN nodes to hold, send and receive funds on behalf of its customers, this likely makes these transactions within the scope of the state money transmitter licenses. This makes sense, as you are holding other people’s money, and are able to run away with it, bet it all on red in Vegas, or lose it via negligence. This is why Money Transmitters are required by each US State to prove they hold funds 1 to 1 (sometimes in super safe “permissible investments”), why they need to post a bond, etc.
However, if a node is merely routing packets of data between one node and another, this seems to fall outside money transmitter activity, because the routing node does not at any point control or hold custody of the funds.
Custodians of Funds vs Information Movers
To illustrate the above, take the following example. Alice goes to CVS and buys a prepaid Visa Gift Card issued by Boomer Bank, packs it in an envelope, and ships it via FedEx to Bob. When Alice purchases the funds at CVS, Boomer Bank ultimately has custody of her funds, and she is entrusting them to hold and not lose the funds. Naturally, Boomer Bank is the licensed Money Transmitter here, and would need license from each state it operates in.
After Alice ships the card, one might argue that since FedEx is temporarily holding the card with the funds, they are a money transmitter. I mean, they’re quite literally transmitting money! Shouldn’t they be bound to the money transmitter laws, register as an MSB, have an AML compliance program, etc?
Of course, imposing such a requirement this would be a nonsensical burden, and wouldn’t serve to protect anyone. FedEx, being in the shipping business, is merely transporting a package of information for a fee. This is essentially what routing nodes do. Like a shipping company, they are paid to move information for a fee, and that’s it.
In fact, Lightning Nodes are arguably less in control of the funds than FedEx in that example. Imagine the instance where a rogue employee rips open the FedEx envelope and steal the funds. With LN, this is not even technically possible. A routing nodes never has custody of the funds it is routing, has no ability to steal the funds, and does not know where they came from or where they are ultimately going.
Importantly, trying to force every routing node on the lightning network is not only nonsensical, it is impossible. Any regulator that tries to impose such a draconian rule will ultimately fail. How will they stop a random hobbyist from plugging in a $40 raspberry Pi and using it to route LN traffic via Tor? Even if a country bans it, they will not be able to stop it outside of their jurisdictions. And besides, who would that protect exactly? Certainly not consumers looking for new payment methods. It would likely protect big banks and owners of traditional payment rails.
Trust
In coming to a decision on how to regulate this space, I hope our government officials recall the whole purpose of state money transmitter licensing. As one US State puts it, it is to ensure that citizens have access to a “wide array of properly operated money service providers…and also for the protection of the interests of consumers who are served by these entities.”
Requiring custodians of funds (whether those funds are denominated in USD, bitcoin, or any currency) to register as a money transmitter ostensibly makes sense, because we don’t want shady custodians absconding with customer funds.
The MTL laws make sense in a world where you need trust. I need to trust that Boomer Bank does not gamble with my funds. But bitcoin does not require trust; that is the whole point. If I choose to trust a custodian to handle my bitcoin, that is when MTL laws should apply.
But treating trusted custodians in the same way as trustless information movers is not only nonsensical, it is also sure to ultimately fail in its intended purpose.
