Layer-2: Payment channels and the Lightning Network

A payment channel allows two users to make an arbitrary number of rapid, two-way transactions with zero fees between them without involving the Bitcoin blockchain. Inside the channel, a user makes a payment by assigning funds to the other side using a digital signature. As long as both users agree on the payments this back-and-forth can go on forever. Any side can at any time unilaterally close the channel. Both users can then prove the latest valid channel state to the blockchain, which is declared final. Only to open and close channels, do users need to record the opening and the closing transaction on-chain; all channel payments are off-chain and private.

While such 1:1 channels are nice, they are cumbersome and near impossible to use in larger networks because to connect N users completely, N^2 channels would be needed. Therefore, the possibility to route payments through the network without needing to trust the peers along the route is a second key feature of Lightning. The protocol implements payment routing with “Hash Time-Locked Contracts (HTLC)”. Such a contract locks the payment (plus a fee) until the receiver unlocks it or until a certain amount of block time has passed in which case the sender can access the funds again (cf. BIP-112). Routing a payment means having a series of HTLC contracts on the way, for which the peers receive parts of the routing fee because they provide liquidity to let the payment flow through the network. While base chain fees vary with transaction size in bytes, Lightning fees vary with payment amount. They consist of a base fee plus a fee rate per Satoshi (sat) sent. For example, sending a typical remittance amount of USD 200 (ca. 318640 sat) would cost less than 1 US Cent (12.4 sat, cf. fee statistics). It remains to be seen how Lightning’s different economics for a fee market play out compared to on-chain fees that are based on the byte size of transactions.

For the time being, it is impossible to transact such amounts on that level of privacy using fiat currency. From this perspective, El Salvador’s experiment to accept Bitcoin alongside the US Dollar seems quite reasonable as it offers the 70% of the population that is unbanked and relies on remittances from abroad for 24% of their income the possibility to suddenly be their “own bank.”

What about growth? At the time of writing, the Bitcoin Lightning Network capacity (sum of amounts locked across all public channels) has increased by 190% YTD to almost 3100 BTC. The network is powered by 16500 public nodes, an increase of 100% YTD (Figure 2).

Three things are important to understand about these numbers: first, network capacity is not the same as Total Value Locked (TVL) in DeFi protocols – Lightning funds are rather unleashed than locked as they can be sent anywhere on the network while DeFi funds are indeed frozen and cannot move. Second, this estimate is a lower bound because only public channels can be monitored, and it is unclear how many private channels exist (a rough estimate by BitMEX from 2020 indicates a level of around 28% private channels). Third, the more payments are done, i.e., the longer a channel stays open, the higher the savings in time and fee are compared to on-chain. While SegWit made opening and closing transactions cheaper, Taproot will make them indistinguishable from normal transactions, thus adding another layer of transaction privacy.

To sum it up: Lightning is a network of payment channels that offers (practically) free, instant, and private (off-chain) payments that is global and only requires a wallet app on a smartphone to participate. Lightning payments do not require proof-of-work consensus, have no 10-minute confirmation time and require no mining.

Layer-3: “Lightning Apps” and smart contracts on Bitcoin

With renewed focus on Lightning, an interesting trend to watch in 2022 will be the emergence of decentralized applications on Lightning, so-called “Lightning apps (Lapps)”. While LN is chain-agnostic and works on any blockchain that uses the same hashing algorithm for the hash lock (eg Litecoin, Liquid and Stacks), we show here a few select Lapps built on top of Bitcoin (Table 1).

On the more exotic end, sovryn.app is a Bitcoin trading and lending platform built on the Rootstock sidechain, thus allowing smart contracts that are compatible with the Ethereum Virtual Machine. It touts itself as a “Fullstack Financial Operating System” and follows a strict trustless, decentralized approach (Sovryn Black Paper). SOV, the governance and coordination token recently listed on KuCoin, can be staked in the Bitocracy governance system for decision-making and access to launches of sub-protocols. In addition to the features inherited by Rootstock, Sovryn also aims for zero-knowledge-proof shielded transactions in the future.

The final example is dedicated to boost Bitcoin’s Layer-3 innovation space: RGB is a smart contracts layer on top of Bitcoin and Lightning. Still at an early development stage, it promises to offer in the Bitcoin ecosystem, what DeFi users have enjoyed for a while now in Ethereum and its competitors: fungible tokens (e.g., securities, option, futures), nonfungible tokens (e.g., art or game collectibles). However, RGB follows a very different approach to enabling smart contract functionality that, if successful, can take the scalability and privacy of Bitcoin to another level.

First, RGB contracts do not run and are not visible on-chain but are managed in a complex web of user-owned graphs on top of the Bitcoin blockchain. This cryptographically sophisticated design brings several advantages: Off-chain contracts allow for faster processing as no network consensus and no mining is required. They also offer more privacy as they let conventional chainalysis techniques that rely on traceable public transactions recorded in public blocks to come to nothing. Second, RGB makes transaction amounts confidential (cf. Liquid network) and reducing the visibility of contract history to the owners. Third, by separating contract issuer and owner, RGB removes the “life-long” dependency from the contract owner (e.g., on Ethereum and similar chains). On RGB, hiding who runs which contract from non-participating users will increase privacy and also reduce attack vectors of contracts – a problem many smart contract chains have to deal with today. Fourth, RGB relies on the proven security model of Bitcoin’s base chain while benefitting from the speed and privacy improvements of Lightning without requiring both layers to be changed much.

Like improvement proposals and standards for Bitcoin and Ethereum, the Zug-based LNP/BP Association maintains a set of technical LNP/BP standards describing the core concepts. In reminiscence of the open “TCP over IP” standard for the Internet, LNP/BP stands for “Lightning Protocol over Bitcoin Protocol” to hint to the ambition of an open Internet of Money in the future. A less technical audience can find documentation on the comprehensive RGB FAQ website.

Conclusion

The Bitcoin ecosystem is expanding beyond the base layer, extending functionalities for users from gold 2.0 to fast and cheap payments, fungible and non-fungible asset tokens, smart contracts, and decentralized applications. Although some projects are very nascent, if they succeed, the underlying Bitcoin network not only offers them a stable and secure chain but a very large user base around the globe. We may just witness the early beginnings of what may become “Bitcoin DeFi” someday. If the technical promises can be kept, it is well possible that the Bitcoin ecosystem experiences a similar boost as the Ethereum-based DeFi (and NFT) spaces have seen in the recent past. The open question is how long it will take for end users to be able to make use of these developments.

The author thanks Daniel Babbev for review and feedback.