On value and scale in Bitcoin and the Lightning Network

1. Foundations and Blockchains

At 2,073 feet, the Shanghai Tower is the second tallest-building in the world.[3] The tower is a marvel of engineering. It boasts both the world’s highest internal observation deck (at the 121st level) and the world’s fastest elevators (clocking 46 mph).[4] From above, the twisting tower looks like a giant guitar pick. As it rises into the sky, it twists around — approximately 1 degree per floor. This spiraling helix dampens wind currents.

Schematic diagram of the soil-foundation system of the Shanghai Tower.[5]

Beneath Shanghai Tower’s ground level is the foundation that makes this engineering marvel possible. Nearly 1000 rock-solid foundation piles reach down 282 feet into Shanghai’s soft, clay-heavy soil. Above that, a 20-foot-thick block of solid concrete — the ‘raft’ — forms the foundation of the tower.[6] The area below-ground accommodates only five floors compared to the 128 above. Obviously, this heavy and secure foundation is not nearly as inviting or accommodating as the sleek and cavernous structure above. Nor could it be.

Like the foundation of a skyscraper, the Bitcoin Blockchain is a solid base layer. While not alone accommodating the lofty demands of all its users, the Blockchain provides the necessary foundation on which to build systems that do.

In this article we will explain how the Bitcoin Blockchain represents a new class of systems and protocols that are able to store value, pursue a brief inquiry into value, identify some of the Blockchain’s shortcomings compared to prior art systems, introduce the concept of higher layer blockchain protocols and Bitcoin’s layer-2 Lightning Network, consider the structure and connectivity of the Lightning Network, and examine how layer-2 protocols like Lightning change the Blockchain’s privacy and identity model, introducing opportunities for publicly trusted identities.

2. Blockchains and Value

The rhetorical explanation of-the-hour analogizes a blockchain to a distributed ledger. According to another more rigorous — if still lacking in technical specificity — definition, a blockchain is a public, permanent, append-only distributed ledger.[7] While these are a good start, a blockchain is more than a distributed database.

Blockchains are ingrained with units of value, e.g., ‘coins’ or ‘tokens’, that are inextricably intertwined with the system. While a mere ledger provides an accounting of value, a blockchain can also store value. The Bitcoin Blockchain represents the first and longest-running of a new generation of internet protocols that store value.[8]

A poignant question — and from critics a common one — is the following: What gives Bitcoin, and a blockchain token generally, its value? One oft-offered answer is that Bitcoin’s value comes from its immediate and speculative utility as a medium of exchange. More precisely, the idea is that this utility comes from Bitcoin possessing the desirable characteristics of money:[9] it is durable, portable, divisible, fungible, transferable, unforgeable, and rare.

That, however, is not the end of the story.

3. A Measure of Sacrifice

On May 24, a California jury awarded Apple $539 million dollars in Apple’s lawsuit against Samsung for infringement of Apple’s intellectual property — in particular, for infringement of its design and utility patents.[10] This legal skirmish between Apple and Samsung is not new. It has been raging on for the last seven years, including a recent trip to the Supreme Court.[11]

From this, it may seem like Apple and Samsung are archnemeses. It may seem like they wouldn’t be caught dead in the same room, let alone engaging in business dealings with each other. Yet, even today, Apple purchases its iPhone X OLED displays from Samsung. And in prior years, Apple purchased the system-on-a-chip (SoC) for its iPhones from Samsung. How can that be? Why do these apparent foes give each other business?

One way to think about why this is so, is to think about securing the benefits of a business transaction through trust-minimization. Where a unit of exchange requires resources to produce, the unit intrinsically ensures a temporary reduction in fitness[12] — i.e., a sacrifice by the counterparty, through past diversion of resources. Even counterparties who do not trust each other can be sure that the production of each unit secured for them, by the temporary reduction in fitness of a competitor, a quantifiable competitive advantage. Even geopolitical adversaries might consider securing a transaction in this manner.

Bitcoin is based on a proof-of-work system that requires energy and computational resources — more generally, labor — to produce new blocks and to claim the block reward. These computational resources required to produce each bitcoin minimize the trust needed to represent value because each bitcoin is a measure of sacrifice[13]:

Every party to an exchange can be sure that a particular unit was created by work maintaining and securing the system and not by fiat or arbitrary decree, or by speculative debt obligation. In this sense, at least, Bitcoin’s unforgeable nature and the resources required to produce it give it value.

Bitcoin’s mining difficulty is a useful (but likely insufficient) proxy for labor.

4. A New Embodiment of an Old Idea

Throughout history, various commentators — of very diverse schools of thought — have confirmed this notion of value. They called it by various names:

Adam Smith, for example, writing in 1776, referred to this is as the “real” or “natural” price — the cost of the labor required to bring a commodity to market. As Smith said, “Labour alone, therefore, never varying in its own value, is alone the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared. It is their real price; money is their nominal price only.”[14]

Karl Marx, on the other hand, writing in 1867, described a “labour-time” theory of value with all commodities ultimately being realized human labor: “It is because all commodities, as values, are realised human labour, and therefore commensurable, that their values can be measured by one and the same special commodity, and the latter be converted into the common measure of their values, i.e., into money.”[15]

Much more recently, in 2002, Nick Szabo formulated a theory of collectibles that also includes a labor element: the idea of “unforgeable costliness”. Szabo posited the following:

[O]nce institutions involving wealth transfer became valuable, collectibles would be manufactured just for their collectible properties. What are these properties? An important subset of these are products that are unforgeably costly, and therefore considered valuable . . . .[16]

Szabo’s observation makes perfect sense in context, if effective money must store value and if that value comes from the necessary cost of production — i.e., its unforgeable costliness. Adam Smith said as much when he described that goods and money “contain” a certain quantity of labor: “They contain the value of a certain quantity of labour,” Smith said, “which we exchange for what is supposed at the time to contain the value of an equal quantity.”

5. Resource Consumption

There is a popular misconception that the work of mining Bitcoin is wasteful. One reason, among others[17], [18], this is not true is because the work of mining goes to securing the Blockchain by making it unforgeable.

Specifically, the work of mining goes toward creating a data structure that maintains its integrity in the face of security compromises and network failures. Even if all computers in the Bitcoin network are taken offline and all private keys compromised, an attacker can only forge the Blockchain data structure by redoing all of the work needed to create it in the first place. For most attackers that is not feasible, even with time.

Moreover, the cost of securing the Blockchain by mining is recouped over time by the efficiencies gained from the system. Szabo explained this idea as follows:

At first, the production of a commodity simply because it is costly seems quite wasteful. However, the unforgeably costly commodity repeatedly adds value by enabling beneficial wealth transfers. More of the cost is recouped every time a transaction is made possible or made less expensive. The cost, initially a complete waste, is amortized over many transactions. The monetary value of precious metals is based on this principle. It also applies to collectibles, which are more prized the rarer they are and the less forgeable this rarity is. It also applies where provably skilled or unique human labor is added to the product, as with art.[19]

Thus, the work of mining Bitcoin is not wasted: it secures the Blockchain, preserving a practically incontrovertible history in the face of failures; and it is amortized over many transactions in which it is offset by gained efficiencies.

6. Weaknesses

For all its virtues, the Blockchain is not computationally efficient compared to centralized and trust-based systems. This is primarily because, in their lowest layers, blockchains trade computational efficiency and scalability for “social scalability”.[20] That is, they trade a highly manageable and easily pliable computing platform for one that is open, redundant, and robust.

This is not a problem as long as a blockchain — and in particular Bitcoin’s Blockchain — is recognized for the main benefit it provides: a heavy and secure foundational layer. Efficiency, and perhaps policy, can be built on top.

Like Shanghai Tower’s 20 feet of solid concrete and 282-feet-deep foundation piles, the Blockchain forms a solid foundation that provides stability. The concrete foundation needs its sky-scraping tower, and the Blockchain needs layers built on top in order to scale.

7. Layer-2 and the Lightning Network

The Lightning Network is Bitcoin’s layer-2 protocol.[21] Here is how it works:

1. Pairs of users enter into agreements to negotiate in good faith secured by collateral. These agreements, called channels, are recorded in the Blockchain (as ‘funding’ transactions).[22]

2. The default allocation of the collateral in a channel is to return to each party the portion of the collateral they contributed.

3. Each pair uses ongoing negotiations and partially-signed but unrecorded contracts (i.e., ‘off-chain’) to adjust the allocation of the channel’s collateral and defer settlement on the Blockchain. This is called updating the channel.

4. To send bitcoin, the sender updates one of her unrecorded contracts with another party, who in turn updates one of his contracts with another party, and so on, until the process reaches the recipient. The result is a chain of contractual updates.

5. Parties must negotiate in good faith (including by disavowing past revoked or updated contracts) or they lose their collateral. If negotiations break down and there is no dispute or breach, collateral can be returned according to the agreed allocation in the most recent contractual update.

By deferring recording to the Blockchain, the Lightning Network allows a higher transaction volume and near-instant confirmation:

Transaction Volume. The speed and capacity limits of the Blockchain itself do not directly limit Lightning transactions. Lightning’s automated and near-instantaneous negotiations and contractual updates do not need to be recorded in the Blockchain immediately — i.e., they can occur off-chain. Instead of limiting the speed and volume of transactions, the Blockchain limits the speed and volume of dispute resolution and settlement. Provided that disputes and settlements are much more infrequent than day-to-day transactions, the Lightning Network can achieve a very high degree of transactional scalability.

Near-instant Confirmation. A standard Bitcoin transaction cannot be said to be “confirmed” until it is included in the Blockchain — i.e., until it is included in a block with some number of additional blocks chained after it. Before this point, the transaction is still susceptible to double-spending. The Blockchain’s proof-of-work does not protect a transaction that is unconfirmed.

In the Lightning Network, although settlement to the Blockchain is deferred, it is deferred in a trust-minimized way. When a Lightning payment is completed, it immediately receives the trust-minimized protection that comes with Lightning Network transactions — i.e., if a counterparty breaches an unrecorded contract, she forfeits her collateral. As a result, Lightning payments, while off-chain and technically unconfirmed, are effectively final, nearly instantaneously.

8. A Different Kind of Lightning

In the late 1800s, Thomas Edison and Nikola Tesla battled over the future of electric power. Edison, a business-minded inventor, wanted to provide power using direct current. Tesla, an eccentric visionary, favored alternating current.[23] With direct current, current flows in only one direction; with alternating current, current reverses direction many times per second, oscillating back and forth.

One key advantage that alternating current provided was more efficient distribution. It is much more efficient to transmit electric power at high voltages. This is because, for equal power, higher voltage results in lower current, which leads to less heat dissipation in the wire.[24] High voltage power transmission, however, requires both generating a high voltage and stepping down that high voltage near its destination. For alternating current — and not for direct current — this was possible and practical using (inductive) transformers. This ability reduced the cost and efficiency of distributing power via alternating current.

A standard Bitcoin transaction is more like direct current, with each bitcoin moving in one direction, in one transaction, from source to destination. Like a garden hose, what goes in one end is what comes out the other.

In the Lightning Network, however, bitcoins oscillate back and forth within each individual channel. In a Lightning transaction, a single bitcoin does not move in a single transaction all the way from the initial sender to the ultimate receiver. Instead, the Lightning Network forms a vast network of oscillating bitcoins, with each individual bitcoin only moving back and forth within a single channel. Like Newton’s cradle, a bitcoin shifting on one end starts a momentum transfer that results in bitcoin shifting on the other.

Newton’s cradle.

Like transformers for alternating current, nodes in the Lightning Network can maintain channels of different values, creating large channels with other ‘high-power’ nodes, while directly maintaining arbitrarily small channels with other users. In doing so, such nodes can act as transformers, converting a very high capacity flow to manageably small flows well-suited for day-to-day consumer transactions.[25] Likewise, such nodes can aggregate small flows travelling in a similar direction for bundled transport over higher capacity channels. Where endpoint nodes have limited network connectivity or computational resources, such high-capacity nodes may also be able to handle some routing and channel-monitoring tasks.

With significantly less transaction volume requiring immediate access to the Blockchain, the ‘resistance’ of the Blockchain’s limited speed and capacity is much less of a barrier to scalability.

9. Network Structure: The Rich Get Richer

Vilfredo Pareto, a 19th century Italian economist and avid gardener, noticed that 80% of his garden peas were produced by only 20% of his peapods. Inspired and intrigued, he went on to show that approximately 80% of the land in Italy was owned by 20% of the population. This principle is known as the ‘Pareto principle’ or the ‘80–20 rule’, and it sets the stage for a mathematical construct — or, more precisely, a probability distribution — known as a ‘power law’.

Many years after Pareto, Professor Albert-László Barabási and his colleagues at Notre Dame undertook to study the connectivity of the world wide web. They were surprised to find that the connectivity of the web followed a power law, with many pages having a few incoming and outgoing links and a small number of pages with a very large number of such links. They went on to discover that many other complex networks follow this pattern: for example, actors in Hollywood, authors of mathematical papers (à la Erdos number), and the number of molecules interacting with k other molecules in the web within a cell, all follow a power law distribution.[26]

A bell curve (top left) characterizes links in a national highway network (bottom left), while a power law distribution (top right) characterizes links in an air traffic system (bottom right).[27]

Searching for an explanation, Barabási and company observed that while quantities in nature tend to follow a bell curve, “all that changes if the system is forced to undergo a phase transition”. Instead, such emergent networks tend to follow a power law distribution in terms of node connectivity. Barabási viewed this as incident to the departure of chaos in favor of order, and as driven by powerful laws of self-organization: ‘growth’ and ‘preferential attachment’. [28]

The Lightning Network is an emergent network. As it grows and transitions from its early stages to a mature complex network, the distribution of links between nodes (i.e., channels) may tend follow a power law distribution. The Lightning Network has already exhibited both growth and preferential attachment. Indeed, the principles of preferential attachment seem especially likely to hold where the cost of establishing a link is independent of geographic location — and there is, therefore, little incentive to prefer nodes that are ‘closer’ to you.

Additionally, because a Lightning channel must be funded, nodes having a large amount of available funds can maintain more (and higher-valued) channels. If, as Pareto observed, the distribution of funds follows a power law, channel connectivity of Lightning nodes will likely follow a similar distribution.

As highly connected hubs emerge in the Lightning Network, they will still be trust-minimized. Channels are protected by the rules of the Lightning Network, and nodes can unilaterally close channels. Additionally, as long as barriers to entry remain sufficiently low, it should be easy to route around nodes exhibiting monopolistic behavior, and market incentives should encourage this. Most importantly, all collateral — i.e., all potential liabilities — are held and secured on-chain, and so as currently designed, there is minimal risk of over-leveraging, default, and insolvency.

10. Privacy and Identity

The Lightning Network establishes a new privacy model.

While identities on the Lightning Network are largely static and public, transactions are known only to counterparties. (Some partial information is available to intermediate nodes in a transaction, and some summary information is available on the public Blockchain.) Presently, a node’s static public identity on the Lightning Network takes a simple form: its public key.

Bitcoin Blockchain privacy model.[29]

Lightning Network privacy model.

In the new privacy model of the Lighting Network, identity and reputation take on renewed importance:

(1) Reputation is important in seeking contracts and counterparties. For example, in opening new channels, reputation enables parties to evaluate more efficiently whether a potential counterparty will honor representations about availability, connectivity, and fees.

Reputation can be based on objectively observable network metrics, such as uptime, number and capacity of channels, and number of breaches and non-mutual settlements.

(2) Public identity is important in authenticating payees, transferees, and merchants. In making purchases, for example, authenticated identities allow a user to verify that a payment is going to the intended merchant, and to validate invoices and receipts.

Verified and authenticated identity is particularly important because it provides efficient protection against man-in-the-middle attacks, which are difficult to prevent in anonymized digital contexts without pre-existing trust.

Public key infrastructure (PKI), which can provide an efficient and contained point of trust, can address both of these needs — reputation and identity — without compromising the trust-minimized nature of the Blockchain.

For example, on the Lightning Network, a node is represented by its public key and (for now) IP address. That public key can correspond to the public key in a publicly trusted X.509 digital certificate. This digital certificate, in turn, can authenticate the identity of the node (by company or domain name, for example) as verified by a registration authority. With authenticated Lightning nodes, users can, for example, ensure that channels are opened with and payments are actually going to the intended party or merchant.

This technique can also be used to authenticate standard Bitcoin addresses. For example, a publicly trusted X.509 digital certificate would allow a user (and her software and hardware wallets) to verify that a particular Bitcoin address is in fact controlled by the intended recipient rather than a man-in-the-middle:

A hardware wallet can use an X.509 digital certificate to verify the identity of a recipient.

11. Conclusion

The Blockchain is a solid foundation. While it is not computationally efficient in the traditional sense, it provides the openness, redundancy, and robustness on which to build.

The Blockchain also provides a store of value. Bitcoins are created by a proof-of-work system that requires resources — or more generally, labor — to produce them. Thus, a competitor accepting a bitcoin can be sure that creating it required a temporary reduction in fitness (via diversion of resources), yielding a competitive advantage. Bitcoin has value, at least, because it is a measure of sacrifice.

While the technology is new, economists throughout history, including Adam Smith and Karl Marx, have agreed that labor is a — or the — source of value. Adam Smith, for example, posited that the market price will always tend toward the “natural” or “real” price: the cost of production. More recently, Nick Szabo captured this idea in his theory of valuable collectibles, in which he recognized the importance of “unforgeable costliness”.

The work of mining Bitcoin is not wasted because it creates a Blockchain that is practically impossible to forge without redoing all the work required to create it in the first place. This is true even if private keys are compromised and the network fails.

The Blockchain is difficult to scale. Nevertheless, it provides the necessary foundation on which to build systems that are highly-scalable.

The Lightning Network is Bitcoin’s layer-2 scaling solution. It works by providing channels between pairs of users that can be updated off-chain. Each pair can continually update their channel by negotiating contractual updates. The channels form a network along which transfers can occur.

Within an individual channel in the Lightning Network, bitcoins shift back and forth. This is similar to alternating current, where electrons oscillate back and forth in a wire (rather than moving all the way from one end to the other, as in direct current). One key advantage that alternating current provided was more efficient distribution using high voltage transmission lines. Similarly, the Lightning Network enables high-value distribution and low-value settlement on the Blockchain.

The Lightning Network is an emergent network, and its connectivity may follow the Pareto principle. In such a network, a power law characterizes the connectivity of nodes, with a small number of highly connected nodes and a very large number of nodes having few links. As highly connected hubs emerge in the Lightning Network, market incentives should encourage routing around monopolistic nodes. And most importantly, all collateral — i.e., all potential liabilities — is held and secured on-chain, minimizing risk of over-leveraging, default, and insolvency.

Finally, the Lightning Network establishes a new privacy model. While identities are largely static and public, transactions are known only to counterparties. In this new privacy model, identity and reputation take on renewed importance. Public key infrastructure (PKI) can address both of these needs without compromising the trust-minimized nature of the Blockchain.