The Breakdown - A Primer on Bitcoin’s Lightning Network

Starting point is 00:00:04 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.io, near NFTX, and produced and distributed by CoinDesk. What's going on, guys? It is Wednesday, June 29th. And today we are looking at Lightning. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dig deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also, a disclosure, as always, in addition to them being a sponsor of the show, I also work with FTX.

Starting point is 00:00:51 So today is the third and final day of me being out for some travel, so I had prepared these episodes in advance. And I thought it would be really fun to talk about lightning and give a little bit of an overview for those of you who haven't spent too much time with it. For those who are deep in the lightning space, this will be very rudimentary and oversimplified. But given how much excitement there is around building new applications on Bitcoin, especially heading into this bare market, I thought it would be a good time to do a little briefing. So first up, what is Lightning, where it came from when it started? Lightning was proposed in a 2015 white paper by researchers Joseph Poon and Thaddeus Dryja. The network itself was first launched in March 2018.

Starting point is 00:01:33 The Lightning Network is one of the layer two solutions for Bitcoin. It is designed to help deal with inherent issues with blockchain such as speed and cost. Remember, while the store-of-value use case of Bitcoin has been front and center for some time now, there has always been a question about how it could also function as a peer-to-peer payments layer. In fact, we fought an entire block-size war about exactly this question. Lightning has been developed by companies like Lightning Labs, whose first $2.5 million seed round featured investors such as Jack Dorsey. So as a Layer 2 network, Lightning's job is basically to do transactions that can be later

Starting point is 00:02:12 batched and written onto Layer 1. Obviously, in this case, the Layer 1 in question is Bitcoin. The way that Lightning works is by creating a web of payments channels that are between users. Anyone can run a Lightning node and open a payments channel with another user. Importantly, the way that these channels work is that they have a certain amount of Bitcoin committed to them. That Bitcoin can be used to transact in the network. Each Lightning node might have multiple open channels to different users, and so the way that it works is when chained together, they can route payments through the network even if two users don't have a direct connection. The nodes in the network keep track of incoming and outgoing transactions in a channel, and when a

Starting point is 00:02:51 channel is closed, the total transactions between the two parties are calculated and the net difference is written onto the Bitcoin Layer 1 blockchain. Lightning uses Bitcoin the asset as its unit of account, or really Satoshi's. Transactions are sent in Bitcoin amounts, and balances are redeemable for layer 1 Bitcoin when channels are closed. A few of the ways that Lightning keeps the core principles of Bitcoin. First of all, it transmits real Bitcoin so it maintains the 21 million hard supply cap at all times. There isn't credit risk in the system like there is in traditional payment rails, because all payment channels are funded in advance. They simply stop making transactions if they run out of Bitcoin to transmit. The system is decentralized,

Starting point is 00:03:31 in a few ways. For example, it's made up of a web of nodes that can facilitate transaction pathways. This design also makes it censorship-resistant and anti-fragile. Payments can be routed around specific nodes that are attempting to disrupt the network or censor payments. Nodes can communicate entirely across privacy-preserving internet protocols like Tor. And because the network only writes the net difference in a channel to the blockchain, transactions can be much more private than regular Bitcoin transactions. Most of all, operating a lightning node is relatively accessible, just like running a Bitcoin node. You can fund a functional Lightning node with as little as a million SATs or around 0.01 BTC, something like $200 worth. Opening and closing Lightning channels

Starting point is 00:04:12 requires a regular Bitcoin network fee, which is at the time of recording below $1, and could typically be done for less than $5, even during more high-demand periods. Lightning has had quite the last year or so. As I mentioned, while many Bitcoiners, myself included, are not in the business of spending their Bitcoin, Bitcoin is ultimately not just for hoddlers. The need for a privacy-preserving and censorship-resistant global payments network is made clear almost every day. And if you need a sense of this, just go listen to Alex Gladstein on either this podcast or any other place that he's been. Even those with high conviction around Bitcoin in many parts of the world and many contexts need to be able to use it for payments as well. Now, of course, one of the biggest developments

Starting point is 00:04:56 for Lightning in the last year came from the recognition by El Salvador. of Bitcoin as legal tender. Although announced last spring, in September of 2021, El Salvador launched their Chevo wallet and pushed for businesses to adopt Lightning as a payment rail. Now, the results have been mixed. Adoption has been slow and patchy. There are questions of pushing people to adopt Bitcoin by mandate. But when it comes to our topic, there is no denying that El Salvador represents an important proof of concept and continues to do so. Despite the issues with getting widespread adoption and questions of the politics around it, the simple fact is that Lightning has worked. You can currently pay for things using Bitcoin over Lightning where it's accepted in El Salvador,

Starting point is 00:05:38 and all of the technical issues have been with the supporting infrastructure such as the Chivo Wallet. Put differently, no fundamental problems with the Lightning Network have been unearthed. Another key development from the last year was Taproot being activated in November. This upgrade to the Bitcoin Network unlocked additional features on Lightning which weren't possible before. Most notably is the ability to send data over Lightning, which is something that Lightning Labs is currently building out. Nexo lets you easily buy crypto with your bank card and earn industry-leading interest rates. Earn up to 16% on crypto and up to 12% on stable coins. Nexo makes passive income easy, with interest paid automatically and daily.

Starting point is 00:06:22 With Nexo, you can also borrow against your crypto at 0% APR and exchange over 300 pairs. receive a welcome bonus of up to $150 in Bitcoin until June 30th at nexo.io. That's neexo.io. This episode is brought to you by NIR, a climate neutral, high speed, and low transaction fee, layer one blockchain platform. NIR is a blockchain for a world reimagined. Through simple, secure, and scalable technology, NIR empowers millions to invent and explore new experiences. Business, creativity, and community are being reimagined for a more sustainable and inclusive future. Reimagined your world today at nere.org.

Starting point is 00:07:10 The breakdown is sponsored by FTXUS. FtXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTCX, you pay no gas fees. Download the FTCS app today and use referral code Breakdown to support the show. Speaking of Lightning Labs, let's now talk about the builders in this space.

Starting point is 00:07:50 If you've been following the El Salvador story, of course you've probably heard of Strike. Strike started off with a wallet design that allows USD to be converted to Bitcoin sent over Lightning and then converted back into USD on the other end. This enables users to transact over Lightning while not being exposed to Bitcoin price volatility. In September, they partnered with payments provider Blackhawk to integrate Lightning payments into the existing infrastructure. They enabled Lightning payments on Shopify stores and in-person retail like Chipotle and Walmart. They also opened access to their Lightning wallet in Argentina in January of 2022. Lightning Labs, meanwhile, has been building the infrastructure that is expanding the use cases of Lightning. As we just talked

Starting point is 00:08:29 about new things were enabled by Taproot, and in April, the company raised $70 million to build the Terra Protocol. Terro is a generic wrapper for assets, and so one of the use cases that they're working on is to enable stable coins to be sent over Lightning. However, because it is a generic wrapper, it will theoretically enable any asset to be transferred over Lightning as well. It's still very early in its development phase, so we don't know how it'll play out, but if it does work, it could solve many of the problems of Bitcoin volatility for payments by giving access to stablecoins, as well as opening up a world of possibilities for Defi on Lightning. Finally, I wanted to mention Square slash Cash App slash TBD.

Starting point is 00:09:07 In December, Square renamed itself to block, signaling that the entire Square family of companies were going to be increasingly focused on Bitcoin and Lightning. Cash App activated Lightning compatibility in February, which instantly gave more than 80 million existing Cash App users access to the Lightning Network. TBD was launched in August 2021 to focus on building Bitcoin infrastructure, and so far, the company's major announcement was Web 5, which came in June. The key thing that they're working on is a decentralized identity protocol, which could enable Defi being built on Lightning to satisfy regulatory requirements. On top of these major companies that are in the news quite a bit,

Starting point is 00:09:43 there are tons of companies building interesting applications with Lightning as an integrated feature, such as the Fountain Podcast app, which allows for Lightning micropayments and tips. Another example is ZapReed that allows users to make micropayments for reading websites, which opens up paper article news or time-based website access payments. The thesis around a lot of these projects is that by breaking down money into much smaller units and allowing real-time transactions, it opens up a whole range of new business models and payment designs that could utilize microtransactions in a way that wasn't possible before. As you've heard me say, I think bear markets are a good time to reflect, re-evaluate,

Starting point is 00:10:18 and figure out what you really want to spend your time on. It's clear that for many, the answer is Bitcoin and Lightning. A couple of big ideas that we've seen floating around in the past few weeks. First is this Web 5 idea from TBD and its intersection with the Lightning Network. Web 5 is in some ways about building the primitives necessary to make something like the Lightning Network a robust set of financial and data rails rather than just a payment rail. The design is hoping to introduce personally-custied identity documents so that you can identify yourself to other people on the Internet without having to give your personal information

Starting point is 00:10:51 to a trusted intermediary. The data transmission will use Lightning Network where necessary to have an encrypted connection. The goal is to provide greater data privacy than currently exists on the Internet. Now, of course, for some Bitcoiners, the idea of providing any proof of identity is just fundamentally off-putting. However, of course, in terms of interacting with the world as it's structured, there are going to be situations where it's unavoidable. Having a way to prove identity without compromising on security could be a big advancement

Starting point is 00:11:18 if it gains adoption. It also could be that the ability to have trusted parties in a form of defense, could be a game changer that bridges the crypto world with the traditional financial world. This gets into another discussion from the past couple of weeks. Ross Stevens from Nidig, Nick Carter from Castle Island Ventures, and Alan Farrington, wrote a piece reflecting on DFI so far and exploring what it might look like with Bitcoin as its base layer and with lightning as a tool. Their paper basically argues that the idea of truly decentralized finance is incredibly powerful.

Starting point is 00:11:50 But the version that they're interested in is one that's built on Bitcoin. in a way that inherits the monetary policy, security, and benefits of decentralization that come with Bitcoin in a way that other crypto assets just can't match. They write, such a financial system would be censorship-resistant and secure, with collateral that is collateral, and sustainably low transaction fees. Yield would mean yield, deposits would mean deposits. A is A. Lightning factors for them theoretically as a layer-2 solution that could take the congestion

Starting point is 00:12:18 off the main Bitcoin blockchain in this type of Bitcoin defy. In their conception, Lightning channels would fundamentally allow users to remain in control of their funds even while providing liquidity. They imagine a scenario in which there should be no chance that collateral is lost when loans to fault. Ultimately, this would add up to a more auditable and transparent form of Defi. Now, for all of this excitement, Lightning remains a nascent technology and certainly nascent in terms of use case. However, things are changing fast. Lightning network capacity grew by 150% in the past year, and as Kevin Rook points out, there are already 100 million people with lightning-enabled wallets on their phone.

Starting point is 00:12:55 Most of them still have no idea. Feels like we're one viral app away from an explosion in new lightning network activity. So there you go. Like I said, just a tiny little very 101-style primer on the Lightning Network. I'm personally really excited to see people exploring this space more and really figuring out what a different type of financial system that is underpinned by Bitcoin could actually look like. For now, I want to say thanks again to my sponsors, nexo.io. near and FTX. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other.

Starting point is 00:13:27 Peace.

The Breakdown - A Primer on Bitcoin’s Lightning Network

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