Around 8 years back, I wrote functional specifications for routing of international payments. To see how the lightning network addresses this problem of reachability is very refreshing to see. Also, what does does tortilla chips, raisins, peanuts and Bitcoin have in common? They all feature in a presentation on correspondent banking made to the IMF. Read on to find out more…
Cross-border payments and its problems
The global cost of remitting USD 200 is on an average 6.5% of the transaction amount. This is more than double the fees that the sustainable development goals (SDG) of United Nations (UN) is aiming for. Also, the number of active correspondent banking relationships have decreased by more than one fifth in the past decade and is still gradually declining. The increased concentration of financial institutions in this market risks the financial inclusion of a some segments of customers altogether. The reason for the decline can be broadly attributed to the regulatory overheads the come along with the business.
Bold digital entrants like Wise have changed he dynamics of this industry but they too are built on the clunky rails of correspondent banking. Distributed ledger technology provides a new way to address this probem. It is the technology that made it possible to have Bitcoin as legal tender in El Salvador and also the tipping feature in Twitter.
But first, the IMF story!
In December 2021, a hoodie wearing Bitcoin entrepreneur, Jack Mallers, was invited by IMF to talk about disrupting cross border payments. Mid way between the presentation, he drew an analogy between cross border payments and tortilla chips — Imagine tortilla chips were financial institutions and raisins were dollars. A tortilla chip in US wants to transfer raisins to another tortilla chip in El Salvador. To execute the transaction, it has to enlist services of a number of other tortilla chips (intermediaries). Each tortilla chip has its own brick/mortar buildings, legacy processes, liquidity concerns and regulatory overheads. Therefore they all charge a cost for processing the payment and it due to the processes, it takes longer to reach the beneficiary.
On the other hand there is a peanut (Bitcoin) that does not need these intermediaries. It can be instantly sent at no cost. However, most tortilla chips have peanut allergy. To solve this problem — the peanut can be coated with raisins and sent across. The institution now uses the rails of peanut (Bitcoin) to transfer raisins (USD’s) without exposing itself to Peanut (Bitcoin). Institutions do not have to worry about the volatility or complexity of Bitcoin. In effect, the customer only transacts in USD’s. Fintechs like the one from Jack Mallers would convert them into Bitcoin and use Bitcoin as a monetary network to transfer them and in the process earn out of the transfer.
The need for lightning network?
The Bitcoin protocol can process 5 transactions per second and the cost of each transaction is on an average USD 2.5 per transaction. Also Bitcoin transactions are confirmed after 10 minutes (probabilistic finality comes even later). While the speed and scale can be fine for large value transactions but if one sees Bitcoin as a electronic payment system as Satoshi envisaged then it would require some alternative. That is where layer 2 mechanisms like the lightning network help. It piggy backs on the security mechanism of Bitcoin and provides scalability to Bitcoin. We can see how it works in the next section.
How does the lightning network work?
(Note: One Satoshi is the smallest unit of account in Bitcoin; it is 0.00000001 Bitcoin. In today’s market price of one Satoshi is equal to 0.0004 USD)
Let’s assume that Alice needs to pay 4,000 Satoshis to Bob for a coffee. Alice can either pay Bob those 4,000 Satoshis on the main chain or Alice can create a payment channel with Bob on the lightning network. Both would have the same transaction cost on the main chain. But a payment channel with Bob would make her subsequent transactions with Bob nearly free of cost. Let’s assume that Alice made the smart choice of opening a lightning channel with Bob with 10,000 Satoshis. This channel now holds the funds in a multi signature wallet. The funds in this channel are now co-owned by Alice and Bob.
There is a always a possibility that after the new channel is created, Bob is not available anymore for providing the coffee. To ensure that Alice’s Sathoshis are not lost forever, Bob and Alice are required to also create a pre-signed transaction that credits Alice with the funds in the channel. This transaction is not broadcasted in the network. It is kept to ensure that Alice can re-claim the funds if in case Bob does not want to serve coffee anymore. If it happens then Alice broadcasts the transaction and gets her Satoshis back from the multi sig wallet
Now Alice pays 4,000 Satoshis to Bob and gets her coffee. The balances in the multi signature wallet is updated to reflect this change. At this point, Alice can play mischief and broadcast the pre-signed transaction that credits her 10,000 Satoshis. So that she can get her coffee and her Satoshis too! The lightning network safeguards against this. When Alice reclaims the 1,000 Satoshis, she is credited with those Satoshis only after a predefined time interval. Within this pre-defined time interval, Bob could provide a revocation key proving that the transaction that Alice used was thereafter updated and not the latest. As a penalty, Alice would lose ALL the Sathoshis in her wallet.
All the subsequent transactions carried out in the channel creates new transactions with the revised balances and makes the previous transactions unusable by giving the aggrieved party a right to impose a penalty. At any point, either of the parties can broadcast the latest transaction and close out the channel and reclaim their Satoshis in the main chain. The wallets shield the complexity of creating these transactions from the end users.
Also, Alice it not required to create a channel with every new person she needs to interact with. Let’s assume that Alice needs to pay 1,000 Satoshis to Charlie. Alice does not have a channel with Bob but Bob does have a channel with Charlie. Alice can leverage the channel she already has with Bob to send 1,000 Satoshis to Charlie by paying a very minimal routing fee to Bob. There could also be multiple channels between Alice and Charlie; a small routing fee can be paid to all the parties within the chain. The wallet ensures that the transaction is executed by all the parties in the chain ensuring the payment to Charlie or none of the parties execute the transaction (atomic). The wallet creates the route for the payment.
With growing number of channels, the lightning network can be viewed as a spiders web and all the parties in it reachable via some finite number of channels. In its present form, the lightning network works well for low value payments. However, high value payments face liquidity issues in the network and as a result do not settle. There is ongoing research on how lightning network can also be used for high value payments.
The number of transactions that the lightning network can process is only limited by the number of channels and the liquidity in them. A payment on the lightning network at present costs 1 Satoshi or 0.0004 USD. In this blog, I had taken the example of how it can disrupt Cross-border payments because that is the clunkiest piece of our payments infrastructure. I want to end with a thought experiment on how we would end up using payments if they were this cheap? Perhaps, streaming payments while you read a blog? Any ideas?
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The World Bank, An analysis of trends in cost of remittance services, Sep 2021 [online via https://remittanceprices.worldbank.org, accessed on 20th Feb 2022]
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