Lightning Protocol Mitigates Bitcoin Network’s Deficiencies as High-Cost, Slow Settlement System like Visa does for Fed Reserve: Report

Bitcoin’s (BTC) usage growth during the last 10 years has been “strong” and “steady,” and on this journey, from its “humble” beginnings, the flagship crypto has progressed through various phases of “differing usage,” according to a new report from CoinShares.

Starting as a “worthless geeky collectible,” Bitcoin soon moved to a “niche instrument of speculation,” before graduating to its more recent and “increasing use as a store of value, or digital gold,” the CoinShares research team noted while adding that such progressions “inches Bitcoin ever closer to the final and most valuable use case: A global and widely used new form of money.”

But widespread usage of BTC as money requires it to be “useful as such,” the CoinShares report added while noting that for bitcoin to reach its final monetary form, it is “not sufficient to be a store of value alone … it also needs to be a viable medium of exchange.”

Bitcoin was created to reliably settle peer-to-peer or P2P transfers without having to depend on third parties, the report explained while noting that to achieve this, it “purposefully” prioritizes security and settlement finality “at the expense of transaction scalability.”

As stated in the research report:

“All decentralized systems face this dilemma as there exists an inescapable tradeoff between decentralization and scalability at the blockchain level.”

In order to maximize security and robustness, Bitcoin’s protocol “encourages decentralization in its network structure, meaning that no specific individual or group is distinctly relied upon to ensure network uptime,” the report noted while pointing out that a widespread infrastructural base is incentivized “by keeping the barriers to joining the network as low as possible.”

The report added that by minimizing participation requirements (computation, storage and bandwidth), Bitcoin can be “effectively operated by cheap and widely available computers, and as a result, the network is kept accessible for as many participants as possible.”

As mentioned in the CoinShares report:

“To optimize for reliable settlement finality, Bitcoin enforces strict and complex rules that ensure time and energy have been expended to confirm transactions.”

Although Bitcoin’s “recipe” to integrate security and finality have “proven fruitful in its aspirations as a peer-to-peer monetary system,” it does come with a few tradeoffs.

Bitcoin requires its transaction record (the blockchain) to “add new batches of transactions (“blocks”) in a process that proves the passage of time to its otherwise uncoordinated network members, and as a result, bitcoin payments are settled incrementally, not instantaneously,” the report explained.

According to the rules, each new batch of transactions needs to be replicated across the entire network and each member has to verify the validity of each transfers, the report noted while adding that these tasks need both time and energy for each participant to perform, and transactions and blocks “also require time to reliably propagate across the network.”

To minimize the incidence of stale blocks, Bitcoin is “programmed to generate blocks every 10 minutes on average,” the report added while pointing out that this ensures that the chance of two miners finding simultaneous blocks “is lowered, meaning a valid block is likely to fully propagate across the network before an alternative valid block is discovered elsewhere.”

As mentioned in the report, the trade-off is that it can take time for a transaction “to make it into the blockchain, and once it’s in, the level of settlement finality it enjoys is determined by how many blocks deep the transaction sits in the blockchain (and the total cost of mining those blocks).”

Apart from batches of transactions or blocks being settled on a “delayed schedule,” they are also “limited in total size,” the report noted. Because these batches of transactions are “replicated across the network, each participating member must sacrifice storage to maintain their own record of transactions and bandwidth to send and receive them.”

The report further noted that this is a cost node operators “must bear to participate in the network, and one for which they are (unlike miners) not compensated by the protocol.” Bitcoin limits these data requirements “as a means to encourage participation and minimize barriers to entry.”

The report continued:

“Depending on the type of transactions the market requests for inclusion in any given block, Bitcoin’s rules require each batch (or block) of transactions to not exceed a certain data size. The actual average block size is not static, but tends to not exceed ~1.3Mb. The maximum theoretical limit is somewhat higher, but not much so. This size limit effectively increases the network’s decentralization and security as it ensures it will remain inexpensive for users to support basic network activities.”

Bitcoin’s capacity limitations and its delayed batch processing “yield a settlement speed of roughly three to seven transactions per second,” the report added while noting that this “equates to around 600,000 transactions per day, which is roughly equivalent to the daily number of transactions on the FedWire settlement network.”

Although it’s probably enough for a settlement system, “it is nowhere near the capacity needed for a retail payment system capable of handling small, casual transactions such as Visa or MasterCard,” the report added.

In order to keep track of new payments via the settlement process, Bitcoin provides a queue that acts as sort of a waiting room for pending payments ( called the mempool). These outstanding payments are “ordered by the size of their offered fee and sit waiting until they’re added to a block by a miner,” the CoinShares research team explained.

Due to its limited speed and capacity, Bitcoin “lends itself to congestion and waiting periods that unfavorably impact senders of low-value transactions (whose transactions are less able to justify competitive fees),” the report added. It also mentioned that if transaction demand gets high enough, “low-paying fees may never make it into the blockchain.”

As mentioned in the research report, Bitcoin needs layered solutions developed on top of its settlement chain to handle the billions of everyday transfers required for bitcoin, the asset, “to take on a role as a widespread medium of exchange.”

Centralized payments aggregators such as Visa, MasterCard, PayPal, and  Square will likely “fill a significant chunk of that role, but this is a ‘risk’ in that these giants are competitors with clout and network effect, potentially eroding the benefits of Bitcoin’s decentralization,” the report added.

But there are also “independent alternatives” out there that “retain a user’s full autonomy over spending, without relying on a centralized service,” the report noted. One such type of system is the Lighting Protocol.

According to the report, Lightning’s primary innovation is its “use of payment channels.” These allow two trading parties “to freely transact in a peer-to-peer manner, using bitcoin, but without needing to use Bitcoin’s hefty finality process for anything other than initiating and ending a series of trades,” the report explained.

This works similar to a “pre-funded tab of sorts, whereby each entity continuously tracks a history of payments as they’re streamed back and forth,” the report noted. Then, if they want to “conclude their trading partnership, they submit the final balance to the Bitcoin blockchain and undergo its robust settlement process,” the report added.

The report also mentioned that payment channels “enable one opening, and one final settlement transaction, to encompass many historical trades.” This “increases the economic density of the bitcoin transactions and splits its fees across a potentially unlimited amount of individual payments,” the report explained.

As stated in the report:

“When Lightning works as visualized, it mitigates Bitcoin’s deficiencies as a high-cost, slow settlement system by adding a layered transport network for cheap, speedy payments. This is quite similar to what Visa and MasterCard do for the Federal Reserve.”

The report also noted:

“Most transactions in the dollar economy never touch the systems of the Fed, they are processed by payment aggregators who in turn use intermittent commercial banks, who then use the Fed for final settlement. Lightning does the same thing for bitcoin transactions, only using the Bitcoin blockchain for final settlement.”

To view the full report, check here.

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