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04 November 2020

Developments for Bitcoin with Liquid and Lightning

Yara Ainsworth

Yara Ainsworth

Head of Marketing und Communications bei Crypto Finance AG

Über den Autor

Author: Samson Mow, Chief Strategy Officer, Blockstream

Source: Building Blocks – Crypto asset developments in the wake of COVID-19. Would you like to read our Building Blocks magazine? Please sign up for your digital copy via the form at the bottom of the page.


Developments for Bitcoin with Liquid and Lightning

The bitcoin must flow

The bitcoin industry is hurtling toward a major problem that requires preparation. Since the 2017 bull market, we have seen glimpses of what this problem might look like with sporadic spikes in transaction fees and slow confirmation times.

Bitcoin’s capacity trade-off

Bitcoin’s strengths of decentralisation, verifiability and immutable monetary policy do not necessarily come at the cost of on-chain transaction capacity. For bitcoin users to be able to run their own nodes at a low cost and for data to be reliably propagated around the network at scale, the size of the blockchain must be strictly limited.

The industry saw the first signs of the decentralisation-capacity trade-off in action during the bull market of 2017-18, when retail demand for bitcoin investments drove unprecedented transaction volumes on the bitcoin blockchain. With only one megabyte of space available every ten minutes (roughly four megabytes post-SegWit), global investors and traders were forced to fiercely compete on the fee-paying market to get their transactions completed quickly.

Most transactions that occur on bitcoin’s blockchain are, for now, trading related. Whether for better or worse, bitcoin’s rapidly increasing price over the last decade has led to bitcoin being significantly more attractive as a speculative asset than as a retail payment network – at least as far as the mainstream market goes.

SegWit and batching

In the aftermath of the 2017 bull market, the bitcoin industry has steadily improved the level of scalability, thanks to the increasing adoption of SegWit and transaction batching among major exchanges, brokers and wallets.

SegWit is predominantly used as a solution for an old bug in bitcoin (transaction malleability) that came with the welcome bonus of supporting more transactions in each block. Plus, transaction batching also enables exchanges to bundle large quantities of transactions to send to their users with significantly lower data usage.

There are more improvements on the way that could potentially increase bitcoin’s transaction capacity, such as Schnorr signatures and Taproot. Blockstream’s research team continues to make key contributions to these proposals, which will further reduce the data requirement needed to send batched transactions and transactions with complex scripting.

AVERAGE PAYMENTS PER BITCOIN TRANSACTION IS ON THE RISE, SUGGESTING THAT THE ADOPTION OF BATCHING IS INCREASING

Source: transactionfee.info

 

SegWit is short for Segregated Witness. It was perhaps the biggest extension of possibilities in building a transaction for the bitcoin protocol. Probably its most notable benefit, SegWit removed transaction malleability. Before SegWit, bitcoin’s cryptographic signatures made it such that transactions could be tweaked to look different, even by people who had not themselves created the transaction. While this would not make the transaction invalid or change what it did – it would still send the same amount of coins from the same addresses to the same addresses – it complicated the deployment of layer two protocols like the Lightning Network. SegWit moved the “witness” data of a transaction, which includes the signature, to a new part of a bitcoin block. As such, it paved the way for the Lightning Network and other layer two protocols.

 

GROWTH IN TRANSACTIONS THAT USE SEGWIT SINCE 2017

It is still not enough

However, if you’re involved in the bitcoin industry, there is a high chance that you believe there is a lot more room for growth and are actively working towards that goal. Meanwhile, compared to 2017, bitcoin has achieved much greater public awareness. Subsequently, there are now many more liquidity sources available around the world, including those at major institutional venues like Bakkt, CME, CBOE, and LedgerX.

If we see a new and sustained bitcoin bull market emerge in 2020-21 – perhaps due to rampant money printing in reaction to the global pandemic – the level of demand seen on the bitcoin market may make 2017 look like a local garage sale. Price discussions aside, even with recent innovations in bitcoin scalability being deployed, they will not be enough to meet this demand. With institutions and HNWIs now competing to get their transactions confirmed in time to catch their entries and exits, the potential for on-chain fees to reach stratospheric levels – into the hundreds of dollars – is there.

Halting the flow

As the industry stands today, a sudden increase in transaction fees and congestion on the bitcoin blockchain would be disastrous. With few scalability solutions integrated and ready to go, traders and exchanges will struggle to get bitcoin where it needs to go on time. Fee estimation technology has made a great deal of progress since 2017 but was shown to be unreliable during recent periods of transaction fee volatility. The resulting friction when transferring between venues will cause liquidity to dry up and become lumpy. Volatility will spike and unnatural spreads will emerge between exchanges, especially across borders, as was seen in by the 20% plus premiums in China and Korea in 2017.

A large portion of the retail market could also be priced out of physical bitcoin purchases by institutional players, who have more flexibility and deeper pockets when it comes to transaction fees.

AVERAGE TRANSACTION FEES HAVE SPORADICALLY SPIKED DURING PERIODS OF HIGH DEMAND

Preparation is key

The good news is that there are already several promising solutions to tackle the impending dilemma that is now emerging within the industry. The bad news is that very few of these solutions have been adopted by the industry yet. It is forgivable given that there is no immediate danger – the bitcoin exchange market is extremely competitive and exchanges have many other priorities calling for their attention.

But this is not an issue that can be taken lightly. The bitcoin trading market is notoriously seasonal, with the vast majority of profits to be made by trading platforms during the few months of the bull market that bitcoin brings us every few years. If investors and traders are struggling to get bitcoin to and from the various platforms, at best it leads to lost profits and at worst it causes customers to migrate to other platforms. During bull markets, infrastructure is typically pushed to its limit too and the last thing anyone wants to be doing is scrambling to integrate a new settlement system.

More generally, transactions that can benefit the most from bitcoin’s unique trust-minimisation properties (e.g. personal transactions and B2B settlements) would suddenly be priced out of the fee market by speculative market action. The majority of on-chain trading transactions are made to and from trusted, custodial third parties. This begs the question of how much of that activity even benefits from the extreme security provided by the bitcoin blockchain?

At Blockstream, we saw the congestion and the demand coming. Together with other players in the industry, we have started deploying solutions that will help keep the bitcoin market flowing in the event of massive mainstream adoption of bitcoin. Our two main projects toward this effort are the Liquid Network and “c-lightning” (one of the key Lightening Network implementations).

The Liquid Network

The Liquid Network is a sidechain-based settlement network built specifically to meet the needs of traders and exchanges. Although the technology is predominantly built by Blockstream, the network is operated and managed by the Liquid Federation, a collection of 53 major cryptocurrency companies. It is like the Libra Association, but with a lot less trust and far more that is verified.

For those unfamiliar with the concept, as a sidechain, the Liquid Network supports the transfer of bitcoin to and from the bitcoin mainchain. Once on the network, bitcoin is represented by “Liquid bitcoin”, which always verifiably matches the quantity of bitcoin held on the mainchain by the network on a one-to-one basis. Liquid also supports the creation of an unlimited number of new assets, which operate on the same chain. For example, Tether’s currency USDT has an issuance on the Liquid Network.

All assets can be fully settled between each user within two minutes. Transactions are also kept confidential: through some clever cryptography, the amounts and asset types involved in each transaction are hidden from anyone but the sender and receiver, while still retaining the sidechain’s verifiability to anyone running a Liquid Network node.

Anyone can connect to the Liquid Network using a light wallet (Blockstream Green on app stores) or node and start transacting, initiating peg-ins (moving funds to the Liquid Network from the bitcoin blockchain) and issuing assets. However, you will need a membership to set up a special function (at the heart of the network) or initiate a peg-out (move funds from the Liquid Network back to the bitcoin blockchain).

A sidechain provides far more flexibility in deploying new technologies directed at niche use cases than the bitcoin mainchain, without needing the creation of a new cryptocurrency and all the technical and economic problems that it entails. Users can continue to leverage bitcoin’s security and liquidity.

Liquid: a pressure valve

Exchanges and traders that are integrated with Liquid (and other solutions like it) before the next bull market will be able to seamlessly continue transactions in the event that congestion hits the bitcoin chain.

While Liquid cannot guarantee low-cost payments – like bitcoin, Liquid also has limited block space and a fee market – it is likely that transaction costs on Liquid will be significantly lower and have faster block times ensuring that settlements will be more reliable.

Although the Liquid Network is not intended as a long-term bitcoin scaling solution (it is instead specifically designed to extend and enhance bitcoin for trading and other financial use cases), it can still offer a short-term opportunity to shift the transaction pressure away from trading applications on the mainchain and onto a dedicated “traders” sidechain.

Ultimately, to really get the industry to scale, both bitcoin and Liquid will require the Lightning Network.

The Lightning Network

The Lightning Network is a layer-two protocol, widely regarded as the most promising project for scaling bitcoin for mass usage. Lightning frees up more space on the bitcoin mainchain by moving low-value transactions to cheaper, faster payment channels, which are settled near-instantly on a second layer.

Through its payment channel design, Lightning not only relieves the mainchain of retail transactions, but it also opens up a myriad of opportunities for new micro-transactions that aren’t possible through our traditional financial system.

c-lightning

Together with a number of independent contributors, Blockstream developed c-lightning. This is a lightweight, high-performance implementation of the Lightning Network protocol that has become the choice for enterprise deployments of the Lightning Network.

As the only implementation of Lightning that is compatible with Liquid, c-lightning enables the creation of a Lightning Network on top of Liquid bitcoin. It will soon be available on top of Liquid assets such as USDT (Tether tokens) as well.

Blockstream continues to be a major contributor to c-lightning and has been part of recent developments such as the addition of plugins that allow developments in any programming language, multi-part payments for larger transaction amounts and keysend payments, which enable tipping via Lightning.

Trading on lightning

While a few exchanges, such as industry heavyweight Bitfinex, have dabbled with Lightning integrations, the adoption rate by traders has been sluggish. This is to be expected given that Lightning is for now, not particularly suitable for many trading applications.

When using Lightning, both traders and exchange operators not only face the hands-on task of managing channel liquidity, but also must live with the absence of cold wallets – funds that need to be online in single-sig wallets at all times. In addition, with the Lightning Network still in active development, the maximum amount of satoshis transferable is currently too low for most traders.

Nevertheless, Lightning’s technology is progressing quickly thanks to its large developer base and funding from various industry participants. Therefore, it is likely that these issues will gradually be solved. Furthermore, as bitcoin’s market capitalisation continues to grow, the now seemingly low transaction amount limit may not look so small in the future, making Lightning an ideal option for retail traders.

It is not just a bitcoin problem

It is important to highlight that the scalability problem is not just limited to bitcoin. There is a dilemma. They can either centralise for scale, losing the key features that made them attractive in the first place. Or they can accept congestion on the blockchain. Subsequently, many public blockchains are starting to show the strain of transaction demand.

A good example is Ethereum, which recently saw a drastic spike in network fees. This complicated operations not only for ether traders, but also those trading tokens issued on top of Ethereum.

Tether’s USDT, which is the largest stablecoin and third-largest cryptocurrency overall by market capitalisation, primarily circulates on the Ethereum blockchain. Therefore, it is directly affected by the network’s rising transaction fees and unreliable confirmation times during periods of demand.

By contrast, USDTs issued on Liquid continues to be settled within a reliable two minutes period and at low cost, plus with all the additional confidentiality benefits. USDTs on Liquid also provide access to the same progress that has been achieved on bitcoin within the Lightning Network, using payment channels to take smaller-value transactions off-chain.

Do not wait, prepare!

Whether you are an exchange or a trader, putting your head in the sand and ignoring the impending issues arising from network congestion will ultimately leave you scrambling to deploy solutions in the midst of a bull market. This is when the most money is on the table. Scaling solutions, therefore, need to be prepared early, so they can be deployed when they are needed.

Novel technologies like Liquid and Lightning will inevitably require some time for platform operators and traders alike to familiarise themselves with their workings and capabilities. With many signs suggesting a new sustained bull market may be just around the corner, now is the time to get ready. The scale of a new bull run will likely be unprecedented and dwarf the level of demand we saw in 2017. The market will reward businesses that are prepared, while being very unforgiving to those who are not.


About the author

Samson Mow, Chief Strategy Officer, Blockstream, is a well-known personality in the bitcoin industry, advocating under the principle of “do not trust, verify” for decentralisation and the need to prioritise security in protocol development. Previously at BTCC, one of the world’s largest bitcoin companies, Samson’s role as COO was to oversee the day-to-day operations and directly manage the exchange and mining pool business units. Blockstream is the leading provider of bitcoin and sidechain technologies. It is at the forefront of work in cryptography and distributed systems.

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