The Lightning Network is making bitcoin a viable medium of exchange
A common misconception about bitcoin the asset and the Bitcoin blockchain is that it is competing at the payment layer with the likes of Visa or Mastercard. I do not believe this to be accurate. As Murad Mahnudov and Nic Carter have discussed in the past, Visa and Mastercard are more akin to layer 2 or layer 3 payment solutions built on top of a base settlement layer. Today, Bitcoin is a much better settlement layer than it is a medium of exchange. As such, the competitive comparison should be with SWIFT, Fedwire, and ACH, in which case Bitcoin completely outshines them all.
These settlement layers are designed to securely handle large transactions on a relatively infrequent cadence compared to payment layers. International bank transfers can take anywhere from 1 to 5 days because these legacy systems are not directly connected. Instead, payments go through intermediaries known as corresponding banks, similar to how passengers often have to take a series of connecting flights to arrive at a destination. These transactions come with a host of fees including bank fees and transfer operator fees that can range up to $50 per each bank involved in the transaction depending on the bank you use. Worse still, banks often inflate currency exchange rates to increase their profits. In fact, Wells Fargo was recently exposed to have routinely overcharged clients on foreign exchange rates.
In the past, I have highlighted a real world example in which a Bitcoin wallet transferred $1 billion worth of Bitcoin that cost the sender a grand total of $0.68 in transaction fees. Better still, these large transactions can finalize in a matter of minutes rather than days because one party is transacting directly with the other party without the need for middlemen or intermediaries. Bitcoin is simply a far superior international settlement layer than any legacy system currently in existence.
While arguably the best settlement layer in existence, bitcoin has not been a particularly viable medium of exchange within the US (though this isn’t necessarily true in other parts of the world). By medium of exchange, I simply mean a currency used to conduct day to day transactions. Think buying a cup of coffee or going grocery shopping.
Bitcoin has faced two main challenges in becoming a medium of exchange: scalability and volatility. However, both historical limitations are starting to get solved.
Scalability
I just explained how bitcoin is excellent at settling large, infrequent transactions but what about the millions of daily, small transactions? The truth is the Bitcoin base layer currently cannot, and likely will never be able to handle that volume of throughput. Each block that is mined has a data size limit (known as “block size”) thus there is a physical limitation to the number of transactions that can be included in each block. Today, Bitcoin can average around 2,700 transactions per block and each block is mined on average every 10 minutes. While this throughput works for a settlement system, it is nowhere near the capacity needed for a retail payment network capable of handling a high volume of smaller transactions in the way Visa or Mastercard can.
In my opinion, this is a feature of the Bitcoin blockchain, not a bug. In software, there is a tradeoff between security and speed. Bitcoin’s blockchain optimizes for security and decentralization which is a good thing if it’s going to handle trillions of dollars’ worth of value every day. And to date, it’s the most secure network ever created. It’s never gone down, never had a fraudulent transaction and never been hacked. Again, this is yet another difference compared to Visa and Mastercard which optimize for speed rather than security as evidenced by the fact that there were 4.8 million reported instances of credit card fraud in 2020.
The question then becomes, is it possible to scale the throughput of the system without comprising the security and decentralization? Enter the Lightning Network.
The Lightning Network is a network of payment channels built on top of bitcoin’s base layer blockchain. This is why it is common to refer to Bitcoin’s blockchain as Layer 1 and the Lightning Network as layer 2. A payment channel simply connects two users and allows them to pass information, or in this case bitcoins, to each other. Here is the beautiful thing about Lightning, you don’t have to set up a channel with everyone you transact with. As the network grows and more users become interconnected, wallets can route bitcoin through various channels, so it ends up at the destination even if the two users aren’t directly connected.
To illustrate, imagine you want to buy a hot dog at a sporting event, but you are sitting in the middle of the row. You hand the money to the person sitting next to you who hands it to the person sitting next to them and so on until it reaches the hot dog vendor. The lightning network functions in a similar manner, transmitting bitcoin from one node to another, finding the optimal route all the while simultaneously keeping the bitcoins encrypted until they reach their final destination or “target node.”
All of the transactions that pass through a channel are bundled into a single transaction that settles on the Bitcoin network. Thus, the Lightning Network can theoretically scale to millions of transactions per second and settle them all on the Bitcoin blockchain as one transaction so that it does not take up much space on the base layer blockchain. Even better, the Lightning Network can execute these transactions in a matter of seconds and costs a fraction of a penny to execute.
It’s almost impossible to overstate just how revolutionary this could be. Keep in mind, there is no Lightning Coin. The Lightning Network sends, receives, and settles in bitcoin, which is a bearer instrument. It’s not credit. There is no IOU. When I send bitcoin to you using the Lightning Network, clearance and settlement is final. Never before have we had a monetary network that can achieve final clearance without any intermediaries or credit. Never before have we had a monetary network that can achieve final settlement this fast. Never before have we had had a monetary network that is this cheap. Never before have we had an open monetary network before where all you need is an internet connection and instantly you have a payment rail that is natively interoperable with anyone else throughout the world. Compare that to ACH, Swift, Venmo, Visa, Mastercard, PayPal, Square, the thousands of various banks, etc… which are all closed networks that either do not talk to each other or have patchwork connections with intermediaries extracting fees. The Bitcoin blockchain and Lightning Network is borderless and operates peer to peer.
The Lighting Network is the fastest, cheapest, most global, and most inclusive payment network ever created and its built on top of the most secure, most decentralized settlement network ever created.
The Lightning Network is not a new idea; the whitepaper outlining the concept was first published in 2015. However, like any other network, it takes a certain level of development and usage to hit critical mass. Thanks to adoption around the world in places like El Salvador, India, and Africa, where individuals are actively using the Lightning Network for trade and sending money to friends and family, we are starting to approach that tipping point.
In April of this year, the Lightning Network reached a milestone of 10,000 nodes and had just over 45,000 payment channels holding 1,158 BTC. Since then, network capacity has continued growing at a rapid pace.
The number of nodes more than doubled to 22,781 while the number of channels jumped to 56,103. For context, it took nearly a year for the number of nodes to double last time from 5,000 to 10,000. Not only has Lightning seen continued growth, but also an increasing rate of growth. For example, public Lightning Network capacity grew by 5% in April, 14% from a higher base in May, 18% from an even higher base in June, and 27% from an even higher base in July. The bottom line is that the number of nodes is growing exponentially (meaning it’s becoming easier for payments to get routed) and liquidity is growing rapidly (meaning the ability for the network to facilitate those trades is increasing).
Today, the main constraint for the Lightning Network is liquidity. Not only do we need to have more nodes on the Lightning Network, but each node also needs to have some BTC stored on it to effectively handle any transaction routed through that node. Thus, as more and more liquidity is added and more channels are created and maintained, more adoption is possible, which kicks off a virtuous cycle. Today, that flywheel is starting to spin.
Even better is the fact that the Lightning Network is getting better every day. Developers are continuing to work on it. Companies are beginning to integrate with it. More and more people are using it. More channels and liquidity are coming onto the network. In other words, the network effects are beginning to kick in and we are approaching critical mass.
Volatility
The second challenge bitcoin has historically faced in becoming a medium of exchange is the volatility of the asset. As a business, it’s hard to price goods with a currency that moves up and down a lot. It’s also hard to rely on a currency as a consumer when you do not know week to week how much purchasing power that currency will have.
The first thing to realize is that the volatility of bitcoin has decreased over time. It’s also pretty safe to assume that bitcoin’s volatility will continue to decrease as the market cap increases and the asset becomes more mature. It’s possible that bitcoin could eventually become a stable asset but that will take time, likely a decade or longer. But what about in the meantime? Even if bitcoin’s volatility continues to decline, it will still be far more volatile than currencies such as the dollar or the euro for the next several years.
What if it was possible to leverage the lightning network and Bitcoin’s blockchain without be exposed to the volatility of bitcoin the asset? That’s exactly what new apps such as Strike are enabling.
When a user downloads Strike onto his phone, he connects the app to his bank account. When the user wants to transact with a vendor, the vendor shows a QR code that the app scans and then debits the dollar amount from bank account, converts it to bitcoin, executes the transaction using the lightning network, and the vendor gets their payment in a matter of seconds. The vendor can then choose to keep the payment in BTC or immediately convert to dollars, euros, yen, or any other fiat currency. Thus $5 sitting in a US bank can now be used to make an international payment in seconds, for nearly no cost, and neither the sender nor the receiver is exposed to volatility of bitcoin.
Putting it all together
We now have the ability to leverage all the advantages of the Bitcoin network while at the same time solving the scalability challenges and avoiding the volatility issues. The growth of the Lightning Network and the launch of the Strike app is increasingly making bitcoin a viable medium of exchange. Case in point: El Salvador. Citizens in El Salvador aren’t using bitcoin because they hope their investment portfolio increases in value. In a nation in which 70% of the economy operates on cash, villagers and farmers are using bitcoin as a medium of exchange, sending small amounts of satoshis (or “sats”) to buy groceries. El Salvador is currently proving to the rest of the world that the lightning network works, and the longer El Salvador uses it successfully, the more likely other countries will also start to adopt it.
I not only expect other countries to take notice, but corporations as well. Every time someone swipes their credit card at Starbucks or McDonalds, there is a 1.5% — 2.5% fee paid by the business. Bitcoin and the Lightning Network has the potential to scale to same throughput but be much cheaper, charging near 0 basis points and saving millions, if not billions of dollars.
If Lightning continues to scale, Visa & Mastercard won’t be able to compete in the long term. There are too many intermediaries and fixed costs in the legacy financial system to achieve final settlement. It takes longer, costs more and it’s not as secure. In other words, its inferior in every way and there are too many structural limitations to do anything about it.
Eventually, corporations will realize they can save money by taking payments in bitcoin. They can then choose to keep the payment in bitcoin which many already hold on their balance sheet or immediately convert the payment back to dollars to avoid any exposure to the volatility. I expect in time corporations will prefer to be paid using bitcoin’s network rather than credit cards.
Even if bitcoin only ever remained superior store of value and settlement network, it could still grow to a market cap worth tens of trillions of dollars. But if it becomes a viable medium of exchange used throughout the world, the upside is nearly limitless.
