Do the economics of participating in the Lightning Network stack up? Or is Bitcoin’s best hope for retail payments doomed to failure?

When the Lightning Network was first proposed as the solution to Bitcoin’s woes, a lot of people claimed it simply wouldn’t work.

Despite some encouraging signs of adoption, it remains very much a work in progress that’s been criticized for UX unfriendliness, centralization, and routing issues.

What is it again?

The network is a second layer solution that allows for instant, low cost, low value transfers of Bitcoin.

It’s required because the Bitcoin network proper isn’t ‘scalable’ and can only process a handful of transactions at any one time.

The more Bitcoin transactions, the slower they process and the higher the fees.

So what’s happened?

An outfit called LNBIG that runs 40% of the entire Lightning Network recently revealed just how uneconomical it is to take part in the system.

LNBIG has $5 million tied up in the network and runs 1800 channels between nodes.

It’s fair to say that it’s an almost wholly charitable endeavor at this point.

“I have 200-300 transactions through all nodes a day, rarely 600. On commissions, I earn 5,000-10,000 sats per day. It’s $0.4-$0.8. It’s $20 [a] month maximum,” LNBIG said.

That’s $20 a month from $5 million tied up in the system.

Or to put it another way, a $48 annual return for each $1 million locked up.

It may be better than negative interest rates, but not by much.

Because it’s not even profit, as it costs LNBIG more than that to provide the service.

“Opening of the channels (closing-opening again) I spent, probably, more than one thousand dollars. Therefore, no earnings now.”

Of course, Lightning Network wasn’t really set up as a way for people to make their fortunes, but the economics aren’t really working if you lose money from participating.

Fees, damn lies, and statistics

BitMEX research found that network participants could earn 1% a year based on BTC staked in the “outbound channel balance” of an LN network node, depending on the routing fee.

That would return $10,000 for every million locked up.

All you have to do to increase returns is:

Analyse the network and look for poorly connected Lightning nodes with high payment demand

Adjust both fee rates and the base fee, monitor the impact of the adjustments, and calibrate for the optimal income maximising settings

Analyse the fee market, for the network as a whole, and the high demand low capacity routes you are targeting

Constantly monitor and rebalance your channels to ensure sufficient two-way liquidity

Implement a custom backup solution for the latest channel states to protect funds in the event that the node machine crashes.

Easy money. It’s that simple.

Lightning is still very much in the experimental stage. However, we discovered that changing the Lightning routing fee rates does impact a Lightning node's fee income. Fee income is maximised with a routing fee of around 0.1 basis points. pic.twitter.com/CKV9bm8wf7 — BitMEX Research (@BitMEXResearch) March 27, 2019

Centralisation

Due to the uneconomical situation, two months ago LNBIG began closing unused (or rarely used) channels to free up Bitcoin which contributed to a big drop in the amount of Bitcoin capacity on the Lightning Network.

It dropped from 1080 BTC in April to just above 830 BTC currently.

One player having such an outsize impact also means it’s not very decentralised just yet.

Locking up BTC

The Lightning Network has been criticized because it requires a lot of money to be tied up in order to achieve something you can do with some newer cryptocurrencies fairly easily.

When you send money back and forth between two users, you’re essentially sending IOUs.

And you need to stump up an amount of Bitcoin between you that’s equal, or higher to, the amount transacted.

If you don’t know the other party directly, then payments get routed through intermediaries which theoretically allows you to pay virtually anyone.

The essential point is that the network requires a lot of Bitcoin locked up as collateral and a bunch of people don’t agree about whether the maths stacks up.

When Twitter publicity stunt The Lightning Torch hit $150 in value earlier this year, it became too large for the amount of liquidity available on many channels.

Problems

Claiming the network model was “economically broken” last year, Emin Gün Sirer of Cornell used an extreme example of why it didn’t stack up.

“Suppose somebody could receive up to $10,000 from Coinbase, and Coinbase has, I don’t know, ten million users. So ten million times $10,000, erm $10 billion… $100 billion dollars gets tied up?”.

“In that future world where they want to do that, LN really takes off, a lot of coins are going to be tied into these payment channels.

There are a bunch of next-generation solutions in the pipes, including Atomic Multi-Path Payments which allows much greater flexibility in joining different amounts of collateral/liquidity together.

So is Lightning Network working?

Depending on who you talk to the Lightning Network is either a rip-roaring success or a dismal failure.

The network’s capacity expanded 87% between January 1 and June 30 this year, with the number of available nodes doubling from 2298 to 4576 according to CoinGeckco.

However, data from 1ML shows the number of channels and the network capacity dropped.

And even its most bullish proponents agree the Lightning Network will need continuous improvements in order to scale up to what’s required.

“The burden on hardware is increasing, and if the growth of channels continues to accelerate, the network will be facing scaling issues in the not-too-distant future.

“Finding an efficient route through a million channels isn’t easy,” wrote Blockstream developers Joe Netti and Rusty Russell in mid-July.

But every new technology goes through a steep growth curve, so it’ll be interesting to see how this network develops.