How Lightning Network introduce credit risk

As a net receiving merchant on the Lightning Network (LN), you have to apply for a loan for the money you want to receive from your sales. This introduction of credit risk has not been communicated well from the LN proponents. And the risk can not be priced correctly with transaction fees, as credit risk is a function of time.

Let me illustrate the situation with an example. Joe is a used car dealer. He wants to accept BTC as payments using LN. His requirements are these:

1. Receive approx $10 000 USD per month through a LN channel.

2. Settle on chain once a month.

So where does Joe begin? He downloads the software, and now he has to connect to the network.

Joe needs a channel to a node that is willing to lock up $10 000 USD worth of BTC in that specific channel for a month. Who is willing to give him that?

At this point, I hope the reader start to see how credit is introduced.

Elizabeth is running a LN node to make money. She has a lot of BTC, and she wants to charge for her service. Currently, her LN node let her charge a fraction of each transaction she relay.

Elizabeth wants to open a $10k USD channel to Joe. But one thing is bothering her. What if Joe doesn’t sell any cars? In that case, she will get her $10k USD back, but not make any money. In reality, she has an opportunity cost. She would be better off putting those funds to work somewhere else.

Her risk will be reduced by doing her due diligence on Joe and his business. Does he usually sell cars at this time of year? Are his customers LN users? How is his health? What is his stock of cars? She has a financial incentive to know as much as possible about Joe and his business. Just like when a bank give a loan.

Because that’s what it really is. It’s a loan.

Elizabeth is clever, and figures out how to solve this pickle. She has to price her service (loan) as a function of time. She offers Joe the channel, on the condition that he locks up some bitcoin in the channel to pay for the interest in advance. With this deal, she doesn’t need to know anything about Joe or his business. She has 100% collateral for the principal and the interest. All the risk is pushed to Joe.

Problem solved?

Not really. Because this is turning into a very bad deal for Joe. He actually has to loan the money he expect to make. And life is unpredictable. The money he loans, will never match his needs exactly. If for some reason his customers don’t show up, he will still pay interest on the money he doesn’t make. And on a good month, the channel will be too small, and he needs a new channel and a new loan with more on chain fees.

So Joe’s response to Elizabeth’s offer is: Thank you, but no thank you. I’ll just use Visa, cash and Bitcoin Cash.





-----------------------------------------------------------------------------------------------------------

I will now talk a little about the “rebuttals” I expect from LN proponents.

“Joe doesn’t only have income. He also has expenses. And he can revert/refund the channel by paying through the channel.”

This is true to some degree. But as stated in the beginning of this article, Joe is a net receiving merchant. He makes more money than he spends. He will also run into liquidity problems caused by LN with this channel refund strategy. In his case, he might have to buy a used car he didn’t really want for his stock just to be able to use his exhausted channel for selling another car. Or he may have to say “Landlord, may I pay the rent for my store one week earlier? I need to refund my LN channel”.

“Joe can just have a small channel of $100 USD worth of BTC with Elizabeth and use other channels to reload it as many times as he wants.”

This is the most ridiculous “solution” I hear from LN proponents. So Joe now needs another node to connect to. Let’s call this node Andreas. Joe needs a $9 900 USD worth of BTC channel with Andreas to achieve his desired result. The credit risk problem is still there, but now on chain fees have to be paid for two channels. The observant reader now understands that adding more channels just increase the on chain fees without removing the credit risk.

“Joe can settle on chain more often. That will reduce the credit risk.”

Yes, but it will increase on chain fees. LN was created to reduce the number of on chain transactions.

“Joe can settle once a year to reduce on chain fees.”

True. But he has to get a loan of $120 000 USD worth of BTC for one year. The interest will be huge.

I wrote this article because a lot of people believe that LN is going to solve Bitcoin (BTC)’s scaling problems. LN has a lot of other problems too. I recommend people to view Rick Falkvinge’s videos on routing in LN. https://www.youtube.com/channel/UC8aCt-P8D9mU3CMjeKUWQwg

And for people new to this bitcoin thing: Bitcoin Cash (BCH) doesn’t have any scaling problems at all, and will never have in the future. Normal users of Bitcoin Cash don’t have to verify all the transactions in the world. That’s what so called miners do. And they are paid to do that job.

Stein H. Ludvigsen Partner in Bitcoin.no





UPDATE: A person on reddit told me I was "dumb and incorrect". He continued with this:

A seller would dump to an exchange, likely through a backchannel with buyers and hubs.