From CoinShares Research Blog by Matthew Kimmell

Introduction

The topic of scaling Bitcoin dates back to its very first mailing post. In response to Satoshi’s original message, James McDonald said, “We very, very much need such a system, but the way I understand your proposal, it does not seem to scale to the required size” — a remark that probably wasn’t the welcome Satoshi had anticipated. Nonetheless, this marked the beginning of a seemingly never ending, complex debate.

No matter how you slice it, discussions on bitcoin scalability regularly reduce to two critical points: transaction speed and cost. By 2018, after enduring years filled with research, internal conflicts, boom and bust price cycles, protocol updates, and the concerted effort of some shadowy super coders, an elegant solution was finally thought to be found. The Lightning Network, the premier layer-2 solution for Bitcoin, billed as revolutionary: near instantaneous bitcoin transactions, at a fraction of a penny’s cost.

How the Lightning Network Works, in a Nutshell

Lightning works in a clever way. It’s a set of rules for how users can exchange bitcoin payments — at internet speed — without having to go through the intentionally unhurried Bitcoin settlement process. Users set up isolated business relationships that connect to form an outside network, and then ping pong payments back and forth with one another, sometimes through other users, while always keeping tab on who owes them and exactly how much. Eventually, when it’s time to conclude a series of trades or settle up a payment history, the final balances are resolved in a single Bitcoin transaction, often referred to as “on-chain” settlement.

Figure shows a simplified structure of a multi-channel ‘Lightning’ network. The numbers reflect the liquidity capacity of each channel, denominated in satoshis (1/100,000,000 btc).

The concept is that singular on-chain bitcoin transaction fees can carry a much larger collection of payments, and users aren’t beholden to Bitcoin’s slower transaction process for each one. It’s about using Bitcoin as a clearing house or system of final settlement.

Challenges in a High Fee Environment

However, now after 6 years of witnessing Lightning in the wild, the big question looking forward is this: What becomes of the promise of broad-based consumer usage — “hundreds of millions of people” — on the Lightning Network in an environment with high settlement fees?

As you know, the major value at the centre of Lightning is the ability to make rapid, inexpensive payments that neatly avoid the usual inefficiencies of Bitcoin settlement. But this isn’t always the case. At least, it cannot be the case forever. In Lightning, an on-chain transaction is first required to ‘get started’. But afterwards, there remains an occasional necessity for settlement, to finalise a set of payments, as mentioned, but also to manage liquidity, secure profits, or even mitigate a fraud attempt. In an environment where the fees to settle bitcoin transactions are sky-high, such settlements may well be a prohibitive barrier. It’s like an egregiously priced toll, necessarily paid to hop on the superhighway, but where one cannot remain forever.

High settlement fees are expected to be common on Bitcoin due to its limited transaction capacity. As more elect to adopt Bitcoin, the increasing demand for transactions will eventually start to exceed the available supply, leading to an imbalance. Bitcoin’s transaction system operates on a free market basis, so as demand outstrips supply, transaction fees will naturally increase as a result. Therefore, as Bitcoin adoption grows, the expected result is for transaction fees to grow alongside it.

Figure shows that transaction fees are dependent on available block space and demand to process transactions. Original Source: Buck Perley, Unchained Capital

The implication in such a scenario is that high enough fees would negatively affect the accessibility of the Lightning Network and, hence, conflict with the commonly held ethos of self-sovereign Bitcoin scaling. Settlement fees are more than an operating cost in Lightning; they represent the cost of entry, management, adjudication, and exit. For the commoner, these fees could make self-sovereign usage of Lightning impractical, and thus compromise their ability to leverage it for everyday, unstoppable payments.

A major promise of bitcoin — that it will be peer-to-peer electronic cash — would in fact be compromised for most casual users if involvement in the network is practical only by relying upon trusted third-party intermediaries.

This problem harkens all the way back to the origin story of electronic cash. The concept of a central institution or entity rising to the level of an intermediary for transactions completely contradicts the original spirit for devising free (as in free-dom) electronic money. To put it to an extreme, it is possible such an outcome might even, with CBDC-like capabilities, strengthen the very financial structures that Bitcoin was set out to displace.

These points are meant to highlight how consequential it would be if Bitcoin loses some of its key properties of being available, verifiable, and censorship-resistant. Maintaining these properties while scaling Bitcoin to levels of worldwide adoption is both the goal and the challenge. While Lightning taking payments off-network solved the puzzle piece as it relates to transaction speed, given the necessity for occasional settlement, it still has limitations in its ability to solve the piece related to transaction cost.

The Future of Bitcoin Custodianship and Scalability

So how do we scale transaction costs? The unfortunate answer today is third-party custodians. Of course, custodianship is a spectrum, and the wealthiest users will find themselves swimming in options, from deploying their wealth with a single entity to navigating a high-fee landscape independently, without sacrificing any sovereignty. The sadder part is that poorer users may be forced to make a deal and possibly consent to whatever scale of centralised control is offered as a trade-off to take part in bitcoin’s inflation protection.

While not perfect, the status quo direction for assuaging such an undesirable future appears to be towards a free-market of federated offerings (think sidechains and fedimints), where competition should drive down costs for the commoner, controls are distributed across multiple parties, and economic incentives are seemingly aligned. It’s better than traditional banking systems, but it doesn’t fully extend Bitcoin’s properties of being completely independent and uncensorable.

Hope for full self-sovereignty persists in the form of protocol evolution, likely initially down the path of covenants (which one is a topic on which entire books could be written). The Bitcoin development community appears keen to continue to investigate updates — including reactivation of previously deactivated features — that can provide opportunities for a new breed of custodianship.

Perhaps settlement costs could be shared among a much larger range of participants. This would be particularly useful when paired with Lightning, where single transactions can already carry a much larger amount of economic activity (see channel factories). Or, perhaps new forms of layered networks will be invented, with seamless incentives and trivial validation costs.

The foundation of Bitcoin is so robust that there is always hope in the promise of a truly open, distributed financial system. From here, it’s mainly about marginal enhancements and how to best preserve its properties when making them.

Despite this, the future of the Lightning Network as a “silver bullet” looks murky as it stands, given it will tend toward centralization in high fee environments. Thus, the experiment toward a high-speed, cost effective, accessible, and neutral payments system continues, urged onward by the unyielding spirit of a community dead set on redefining the limits of financial sovereignty.

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