Bitcoin’s ‘Lightning Network’ Let-Down, Part 1: A Solution to One Problem, a Source of Another

Summary

• Bitcoin’s institutional acceptance continues apace, supporting the price.
• But bitcoin consumes an ever-growing amount of power, raising long-term concerns.
• A proposed ‘Lightning Network’ could help reduce power consumption, but with a key drawback.
• Bitcoin’s claimed relative advantages over other alternative monies, such as gold, are probably overstated.

Bitcoin has recently rallied back toward its prior highs from last month and is now over $50,000 in price again. Two recent reports have doubtless aided this recent surge. They both tout bitcoin’s growing institutional acceptance as a store of value and possible future medium of exchange for all manner of commerce. One report, from Citi’s GPS research unit, sensationally claims that bitcoin could displace the dollar as the world’s premier international trade and invoicing currency. The other, by noted bitcoin advocate Vijay Boyapati, claims that bitcoin is well on track to displacing national fiat currencies generally.

While the two reports overlap in varying degrees, they both hold out great promise for the bitcoin ‘Lightning Networks’ currently under development. These are considered essential if bitcoin is to succeed in finding a growing range of commercial use cases. This is because they are designed to solve what many commentators, including myself, have identified as a critical weakness of the leading cryptocurrency – namely that its network consumes a huge and exponentially growing amount of computing and therefore electrical power.

By some estimates, the global bitcoin network now consumes as much power as New Zealand. At the current growth rate, it will eventually consume so much power as to be uneconomic to support. Today, bitcoin transaction processors are rewarded with a form of seignorage income: new coins for processing and thereby supporting the network. As long as bitcoin remains in a bull market, inviting fresh speculation, this is not necessarily a problem. But eventually, as the network matures and the seignorage income dries up, miners will have to charge transaction fees. Given the power costs involved, breakeven fees are likely to prove prohibitively high, thereby undermining what bitcoin advocates have long claimed: bitcoin is in fact far cheaper to use than national fiat currency, gold or other traditional money substitutes.

Seeing the looming problem, the Lightning Networks are bitcoin intermediaries intended to reduce transactions costs drastically by ‘netting out’ activity internally and then only periodically settling balances externally. As the Citi GPS report explains:

This approach creates a processing layer that sits above the actual blockchain where transactions happen quickly and cheaply, but are only periodically reconciled on the main chain. This is analogous to commercial banks using the Fedwire system for settling large value transactions amongst themselves and internalizing transactions for clients.

And as described in the Boypati report:

Second layer networks, such as the Lightning network, provide the modern equivalent of the promissory notes that were used to transfer titles for gold in the 19th century. Promissory notes were used by banks because transferring the underlying bullion was far more costly than transferring the note that represented title to the gold. Unlike promissory notes, however, the Lightning network will allow the transfer of bitcoins at low cost while requiring little or no trust of third parties such as banks. The development of the Lightning network is a profoundly important technical innovation in Bitcoin’s history and its value will become apparent as it is developed and adopted in the coming years.

Now that it is more generally recognised that bitcoin, as originally designed and envisaged, is prohibitively expensive to use as a practical, day-to-day medium of exchange, at least the technical innovation need not stop there. Unfortunately, as described above, the proposed solution to this, to create centralised networks that clear transactions internally and only periodically externally on the actual bitcoin blockchain ledger, substantially waters down bitcoin’s neutrality and decentralisation. These networks would, in all reasonable scenarios, be national in character, or at least would be regulated by national government authorities so as to prevent money laundering, tax evasion, terrorist financing or other forms of fraud or abuse.

This tension between neutrality, or decentralisation, on the one hand, and efficiency, or centralisation on the other, is characteristic of networks generally. That includes economic, financial and monetary systems. Indeed, Bell Labs mathematicians such as Claude Shannon famously developed modern information theory in the 1940s when they were seeking the most efficient way to link the rapidly growing US telecommunications networks.^[1]

The solution included elements of both. The modern internet, while highly decentralised, nevertheless has necessary points of centralisation. The same is true of the current global payments system, including SWIFT, VISA, MasterCard and other payments firms, which represent additional examples of centralisation layered over decentralisation.

Not myself an expert in information theory, I will not propose how best to solve for bitcoin’s potential international payments efficiency here. I will, however, make a subtle but essential point. The moment decentralised bitcoin becomes the basis for what is in reality at least a partially centralised payments and settlement network, it loses its purported advantage of neutrality versus other currency alternatives characterised by at least some degree of centralisation.

Bitcoin will therefore need to compete with alternatives as it coalesces into centralised networks. It could provide the ‘monetary base’ as it were, but NOT the payments and settlement system, as originally designed by Satoshi Nakamoto. In other words, you cannot have your intangible, neutral, decentralised bitcoin and actually use it too.

In our next report of this series we will explore how Bitcoin could compete with alternatives such as other coins, a global currency unit such as the SDR, or against precious metals.

1. Among other of his discoveries, Shannon realised that the core tenets of nascent information theory used fundamentally the same physical equations used in classical thermodynamics. In other words, there is an entropic cost to creating, transmitting, receiving and processing information. While inside the system the information (enthalpy) can be conserved, information activities nevertheless must add to the overall entropy of the broader universe.

   Yet today, while physicists understand this, technophiles sometimes don’t, hence claims such as that batteries are a ‘clean’ technology, when in fact their raw materials mining and manufacture is amongst the dirtiest, most dangerous and poisonous of so-called ‘green’ industrial activities. ↑