When browsing discussions of the Lightning Network, I find the subject is almost universally on the topic of transaction scaling. Clearly LN (the lightning network) is an amazing solution to the Everest sized problem of exponential scaling. While some focus on scaling as a linear problem, in need of a rather immediate linear solution, LN is one of multiple projects trying to tackle the inevitable problem of 100x and 1000x transaction volume. Unfortunately, this means that a critical and invaluable benefit of the Lightning protocol tends to get lost in the conversation.

What do the names MtGox, BitFinex, Bter, Cryptsy, Bitcurex, Linode, Bitcoinica, Bitstamp, Bitcoin Savings & Trust, and Poloniex have in common? With each of these services, for various reasons, a lot of people lost a lot of bitcoin under the control of these third parties. Scaling is all well and good, but it is certainly not the only problem that needs a solution. Due to the combination of transaction volume, wait times, and interoperability, most exchanges must keep internal records of bitcoin accounts that are not secured by the Bitcoin blockchain. The current landscape of the Bitcoin industry, ignoring the protocol itself, is actually rather centralized. Coinbase is a very widely used service for buying bitcoins. Every transaction within a Coinbase account, switching between wallets, and purchasing on their exchange, are all done internally. We as users, have to trust that the coins we hold in their service exists and is secure. But we cannot know.

So, what does this have to do with the lightning network? The number of transactions on these exchanges at times, even individually, rival what the entire bitcoin network can handle. It wouldn’t surprise to learn of exchanges that do far more transactions internally, than Bitcoin does publicly. Because of this, there is currently no viable option for securing these many, separate, high frequency, high volume exchanges and payment services using Bitcoin’s security model. This is where the lightning network is truly a game changer.

Re-Decentralizing the Bitcoin Industry

The Lightning Network operates by building secure payment channels between users, services, nodes, and any other participants on the network. With these channels, funded with a specified amount of bitcoins, the two participants can make a vast number of instant transactions that essentially occur “off-chain” with the provable, on-chain guarantee that the bitcoins are redeemable. In addition, the channel can be left open without having to trust the service, user, or node that you are connected to. No one has the power to take or move your coins without your explicit consent.

What does this mean? It means exchanges, online wallets, tumblers, investment vehicles, and any other institutions that rely on custodial control, will have the ability to become a lightning node in the place of adopting internal transactions. And can do so without sacrificing the speed or versatility of their service. For example, If I open a channel with a major exchange to buy bitcoin, and another person does so to sell bitcoin, the exchange can bridge our wallet channels without ever removing our coins from our control. The exchange acts as a market facilitator without directly taking control of its users’ money. Of course, this would not apply to any dollars or fiat held with the exchange.

The End of Customers Paying for Weak Security?

Now let us imagine the MtGox scenario. The exchange gets completely compromised by a hacker. If the exchange has open channels with each user who has a wallet, the hacker cannot steal the users’ coins! Yes, the hacker can be a nightmare for the exchange, and yes it can cause serious damage on non-LN coins in storage, but the hacker cannot simply take the coins held in LN channels. The worst damage they can do to the exchange is by closing the channel to access the portion of the balance belonging to the exchange. This would likely be done without the user’s consent, however, it will force them to wait for the lock-time built into the channel (typically a few days). During this time, the exchange could reestablish control, or users could close their channels from their side. If the attacker tries to broadcast an old state to cheat the users, then the user is able to broadcast the valid state and sweep all of the coins from the channel.

Translation; if a hacker gains full control of an exchange that uses lightning channels rather than full custodianship of funds, it gives improved protection for the exchange, it makes users’ funds nearly impossible to steal, may even result in users’ getting unexpected refunds, and means the hacker may profit little in magic internet booty.

The normal market incentives will also highly favor using LN channels. Lets take Coinbase for example. CEO Brian Armstrong, on multiple occasions, has publicly discussed worries regarding higher fees on the Bitcoin network. Using lightning channels not only protects their users, but also eliminates most of the fees for moving coins into and out of user wallets. Users would be able to spend any of their coins purchased from Coinbase immediately to any merchants on their network, or through nodes connected to them, without any fees.

Regulation? Where we’re going we don’t need regulation

Another intriguing consequence of LN is regarding regulation. Bitcoin exchanges will still be subject to the same old regulatory compliance we all know and love, specifically because they hold fiat balances as well as bitcoin. But much of that regulation is a consequence of the exchange or service having custodial control of customer funds. So in the age of the Lightning Network, to what degree does financial regulation apply to Bitcoin payment processors, wallets, and cryptocurrency exchanges if they never actually control customer’s bitcoins?

It is very possible that services that deal solely in crypto could end up being to financial regulation what torrent sites are to anti-piracy laws… a huge pain in the ass. Like torrent sites that don’t distribute actual copyrighted content, cryptocurrency services using LN channels won’t actually control or transmit other users’ bitcoins. Many services may find themselves back in a new and undefined legal grey area.

A Network of Lightning

The Lightning Network topology has been debated heavily and there has been much conjecture about how it will actually be in practice. Will it be widely distributed, loosely decentralized, or tend toward the hub and spoke model? The truth is that no one knows, because the network isn’t created by developers, only the code. The network will be built by millions of individual users. We will likely have some degree of each of these, dependent upon the user’s individual decisions for more or less privacy.

If the hub and spoke model turns out to be dominant, even this “centralized” model is astonishingly more decentralized than the industry we see today. It moves toward solving one of the most prevalent problems in the bitcoin world since its inception, third party control of private keys. And it does so while simultaneously opening to a level of transaction scaling that is so vast we can really only begin to speculate.

In my visions of a LN future, I see the hub and spoke topology being the short term result of its implementation. Although, as time goes on, it is likely the network will become gradually more and more decentralized. Early on in the LN growth, a highly connected node will have significant value by connecting users who cannot find routes to others. However, the more broadly used and connected the network becomes, the less necessary or useful any single, highly connected node is.

End Game

With the adoption of Segregated Witness and the announcements of support progressing quickly within the Litecoin network, we may first get to see the full benefits of this technology on one of the original altcoins. With a smaller market cap and some distance from contentious Bitcoin politics, Litecoin is able to take greater risks. It may get to be the first to see this incredible innovation in action. In later articles I’ll explore how the Lightning Network can bridge channels between different blockchains, possibly allowing users to spend their Litecoin at any merchant in the world that accepts Bitcoin.

Without a doubt, the Lightning Network presents both an astonishing scaling and security benefit for the cryptocurrency industry as a whole. People will always see what they choose to see when it comes to the consequences of new technology. But to speak for myself, I’m pretty damn excited!