Creative destruction through payment channel networks
Every economic development is based on the process of creative destruction. The term was introduced and popularized by Joseph Schumpeter, one of the most influential economists of the early 20th century.
In his works, he characterized innovation as the determining dimension of economic change.
He reasoned that technological innovations often lead to temporary monopolies which allow for exceptional benefits, only to be soon eroded by competitors and imitators. According to him, these temporal monopolies are necessary to incentivize businesses to develop new products and technologies.
Monopolies in online payments
At present, the biggest monopolies for online payments are built around large credit card processing companies. The largest credit card networks are VISA and MasterCard. In Europe, the market for credit card payments is essentially divided into two fractions, with the share of Visa Europe Services Inc. corresponding to around 60%, and MasterCard Inc. covering the remaining approx. 40%.
4-party payment structures
Not taking into account the credit card network as a separate entity, payments made through credit cards are carried out in a so-called four-party system. That involves 1) the payer (cardholder), 2) the payee (merchant), 3) the issuer and 4) the acquirer. The issuer and the acquirer are payment service providers who operate on a credit card network.
3-party payment structures
In analogy to the 4-party system, there is also the three-party system. That means that the payer and the payee use the same payment service provider. One famous example of such a provider is the American company PayPal Inc.
Micro- and p2p-payments
While the Internet and its inherent free flow of information have democratized access to knowledge, it has not yet democratized the flow of payments. Existing structures not only limit transaction partners to people who are considered “banked“, but also prevent the inexpensive implementation of micropayments.
For low-value goods, the cost-effectiveness of payment is a key problem: Conventional methods are unsuitable because the costs of payment processing often exceed the value of the goods.
As such, cost-effective ways of implementing micropayments usually require the involvement of additional parties in the payment handling process (gatekeepers), the prior provision of funds (prepaid), or the bundling of several payments into one.
Novel payment rails
What all these workarounds have in common is that their inflexibility prevents them from being smoothly integrated into the existing Internet infrastructure. Consequently, a solution can only originate from an internet-native type of payment process. All payment processes, as well as the underlying infrastructure, must operate on a purely virtual, protocol basis.
The Lightning Network, a scaling solution for blockchains, has paved the way for this kind of evolution.
Payment Channel Networks
By design, the new type of payment network is based on a decentralized, democratized model of payment flows. This instant and microtransaction compatible value transfer is enabled by the concept of bidirectional payment channels. Using payment channels on blockchains, recurring payment parties can pay each other at zero cost an unlimited number of times without third-party involvement. This level of transacting greatly exceeds the capabilities of existing payment networks.
Even if two transaction partners have not established a direct channel to each other, they are able to pay each other through one or more intermediaries who forward the payment (for a microtransaction fee) from the payer to the payee.
In fact, this technology is gaining momentum. As of January 24, more than 80,000 public payment channels have been established and around 18,000 nodes have been booted into existence. That’s a staggering 138% growth in public payment channels and 112% growth in nodes in 2021 alone.
But that’s just half of the story: the miniaturization and low barriers to adopting the technology allow any smartphone user to operate private payment networks with others, thereby creating new structures of how people can pay each other in the digital realm. It does not require companies to process the payment and reflects the interconnectedness of autonomous participants.
In addition, the existing p2p-infrastructure unlocks new opportunities for the emergence of novel applications that leverage the underlying capability to exchange data in a censorship-resistant manner.
If Joseph Schumpeter could witness these dynamics happening now, what would he say? Would he perceive an alternative payment network as the result of a creative destruction process? Might he even assign it the status of a technological basis, his beloved Kondratiev wave?
History has shown that the disruptive power of innovation is often underestimated, even by thought leaders. Likewise, they have difficulty predicting what unprecedented innovations will emerge. To what extent the process of creative destruction of payment channel networks will take us continues to be a fascinating one.
Got curious about the technology? Give it a try!
Getting hands-on experience is always the best way to grasp new technology. Here are three things to try. Ideally, you have already downloaded and installed a lightning-compatible wallet such as Muun.
- Buy a link on LightningButton.com: This is a nice way of showcasing how to integrate lightning payments into an existing tech stack.
- Fulfill a task on Microlancer.io: Have you ever been microlancing? This is a great introduction to how freelancing can be done if it's unlinked from existing payment processes.
- Building your own node (advanced): If you are comfortable setting up operating systems, this is something for you. Become a payment processor yourself by routing payments around the globe.
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