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Blue Fox Notes
Foreword: The Lightning Network is still in its infancy, and many problems need to be solved. One of the controversial points is about the incentives of routing nodes. The Lightning Network must not only ensure the users low-cost payment experience, but also achieve sufficient income for nodes, otherwise it will be difficult to attract profit-oriented nodes to enter. How to find the balance between the rate of return of locked funds and the low cost of users is the key to the Lightning Network. need to be resolved. The author of this article is BitMEX Research, translated by the Blue Fox Notes community Sien.
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overview
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I have written about the Lightning Network before, but today, as the Lightning Network moves from theory to practical experiment, it is necessary to take a look again. This article primarily analyzes the Lightning Network from a financial and investment perspective, specifically regarding fees and incentives for Lightning Network providers. This article does not cover the technical aspects.
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routing problem
However, we believe its main challenge is the interplay and balance between financial and economic liquidity provision and payment routing. Lightning network node operators need to be incentivized by routing fees to provide sufficient liquidity and achieve smooth payment completion. Liquidity needs to be allocated exclusively to in-demand channels, and identifying these channels is challenging, especially as new merchants enter the network.
There is a fee balance challenge here. On the one hand, it is necessary to ensure that the network is low enough for users, but on the other hand, it is also necessary to ensure that the fee is high enough to incentivize liquidity providers. The severity of this problem and the rate at which the market clears may depend on economic conditions.
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Lightning Network Fee Market Dynamics
For Bitcoin on-chain transactions, users (or their wallets) specify a fee for each transaction when paying, and miners will choose transactions with higher transaction fees to try to produce blocks in order to maximize fee income. In contrast, the Lightning Network currently seems to be taking the opposite path. The node operator sets the fee, and then the user chooses the payment path and selects the channel to minimize the fee.
That is, the Lightning Network, initially set fees by node providers, not users. Therefore, the Lightning Network can provide a superior fee structure. Since providers provide specialized services, it is more appropriate to compete on fee rates among providers rather than ordinary users. The priority is simplicity.
Base Fee: A fixed fee, expressed in thousandths of a satoshi, that is charged each time a transaction is routed through a payment. For example, a base fee of 1,000 per transaction would mean a base fee of 1 satoshi per transaction.
Rate: Refers to the charge based on a certain percentage of the payment value. This is expressed in millionths of a satoshi transferred. For example, the rate of 1,000 is 1,000/1,000,000, that is, 0.1% is its fee. Once the transfer is successful, the routing channel will charge 0.1% of the transfer value. Equivalent to 10bps.
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investment capital
In order to provide liquidity for routing payments and thereby earn fee income, Lightning Network node operators need to lock capital (Bitcoin) in the payment channel.
Two types of channel capacity
Inbound capacity (capacity entering a node)
Inbound liquidity refers to the funds in the payment channel of the node, which can be used to receive payments. These funds are owned by other participants within the Lightning Network. If the payment channel is closed, these funds will not be returned to the node operator.
There are two ways to create in-node balances: 1. when another network participant opens a payment channel with the node 2. when the node operator makes a payment through an existing channel
Outbound liquidity refers to the funds in the node payment channel, which can be used for payment of outflow of funds. These funds are owned by node operators and are partly their investment capital. Node operators may consider the opportunity cost of other investments, taking into account the total outbound balance. If the payment channel is closed, these funds are returned to the node operator.
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Source: Bitcoin Lightning Wallet, Note: Orange balance is inbound capacity (incoming node), blue balance is outbound capacity (outgoing node)
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How the Lightning Network Fee Market Works
Becoming a successful routing node is harder than one might imagine. At the time of writing, there are 7615 public Lightning Network nodes according to 1ml. However, out of these nodes, there are probably only a few hundred that are functioning well, and these nodes provide liquidity through node management, rebalancing channels, and setting appropriate fees.
Node operators may need to:
l Adjust the rate and basic fee at the same time, monitor the impact of the adjustment, and recalibrate to achieve the optimal revenue setting.
l Analyze the network and look for Lightning Network nodes with high payment demand but difficult to connect, such as new merchants
l Analyze the cost network, not only for the entire network, but also for the high-demand low-capacity routes you are targeting
l Continuous monitoring and rebalancing of channels to ensure sufficient two-way liquidity
l Implement a custom backup solution for the latest channel state to protect funds in the event of a node computer crash
These technical challenges may simply be adjustments to equilibrium market rates. The harder these problems are to overcome, the higher the potential return on investment for channel operators and the greater the incentive to solve them. This will be a requirement that drives Lightnings success, not a challenge for node operators.
For the Lightning Network fee market to function, node operators may need to adjust fees based on competitive conditions, which can be algorithmic or manual, with the goal of maximizing fee revenue. To mimic what may eventually become standard practice, BitMEX Research attempted to modify the rates on nodes over a three-month period, as shown in the next section.
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rate experiment
This experiment attempts to assess the state of the fee market. Although the Lightning Network is currently in its infancy. We set up Lightning nodes and change the fee rate periodically, trying to determine what rate will maximize fee revenue, as node operators ultimately want to do as the network scales.
Therefore, based on this experiment, it seems that the fee rate for maximizing revenue is around 0.1bps, which must be very low compared to other payment systems. However, this is only the cost of one hop, the payment may have multiple hops. At the same time, the Lightning Network fee market hardly exists at present. In fact, only a few Lightning Network nodes are trying to maximize economic benefits through fee adjustments.
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(Source: BitMEX Research) (Chart of Lightning Network Fee Revenue Data - Notes and Captions)
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*Daily data period: from December 31, 2018 to March 24, 2019
*Data comes from a Lightning Network node
*The base fee for the entire period is 0
*The return on investment data does not include transaction fees on the Bitcoin chain. When the impact of fees is included, the bar chart of the optimal expense ratio shows a negative return on investment
*The data includes weekdays and weekends. Generally speaking, the network traffic of Lightning Network on weekends is significantly lower than that on weekdays.
*The fee rate will be changed at 21:00 UTC every day. Rates decrease each day, then rise to the top of the fee range after a few days of decline, starting the next rate down cycle. The reason for this is that some wallets (such as mobile wallets) dont always ask for a fee when it tries to route a payment through a node, so when the fee rate increases, many payments fail. For example, when opening a channel from a mobile wallet to a node, then, increasing the fee rate and immediately trying to pay, the payment often fails because the wallet tries to pay with a fee that is too low. It appears to us that in order for the Lightning Network fee market to function, node operators may need to change fees regularly, so wallets may need to query fee rates more frequently.
*Channel rebalancing is handled manually, once every two weeks. about 30 minutes each
* Lightning network nodes run on LND, and the software is updated every two weeks
*Approximately 30% of channels (by value) are opened using automated operations, and the remaining 70% are manually operated
*The return on investment is calculated by obtaining the channel outflow capacity of the network every day, calculating the annualized rate of return on investment based on the daily fee income, and then calculating the simple average of all dates based on the rate within a specific range.
*We tried to use public nodes for this experiment, however, fee income is too sporadic, with some network participants regularly paying far more than advertised, making the data less reliable.
*Unfortunately, we need to use a logarithmic scale for both axes. Considering that we are not sure what fee rate is appropriate to set, or even what magnitude is appropriate, we have tried a wide range of fee rates, from 0.0001% to 0.5%, so a logarithmic scale is appropriate. At the same time, daily fee income is highly volatile, ranging from 0 Satoshi to over 3,000 Satoshi. Therefore, it is best to use a logarithmic scale for labeling. As the network grows and becomes more reliable and fee market intelligence improves, a linear scale may be more appropriate.
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In addition to daily fee income, consider the annualized return on investment and various fee rates associated with running a Lightning node. This is calculated by annualizing the daily income and dividing that number by the daily liquidity flowing out of the node.
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Calculate the annualized investment income of lightning network nodes according to the cost column chart
(Source: BitMEX Research)
Of course, liquidity providers in the current Lightning Network are unlikely to be driven by return on investment. Current node providers are more of a hobbyist, and most node providers have a loss when considering the on-chain fees required to open and rebalance Lightning channels. While hobby-based liquidity can sustain the network for a while, in order to achieve the massive scale everyone expects from the Lightning Network, more investors need to be attracted by the potential return on investment.
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Lightning Network Fees and Economics
A 1% return on investment may seem attractive in the current low-yield environment, but the Lightning Network may have trouble attracting the right commercial liquidity providers from the start. Investors in this field are looking for high-risk and high-return investments. This appeal seems to be completely opposite to what Lightning Network provides, because it provides liquidity providers with relatively low-risk and low-return investment returns. Thus, a new type of investor may be needed to fit this profile.
If the Lightning Network reaches a large scale, it has the potential to become a highly liquid investment product with a stable low risk return, which is sensitive to economic conditions.
Consider the following scenario:
l The Federal Reserve base rate is 1.0%
l Lightning network node operators usually earn 1.5% annualized investment income on their outbound balance (node outflow)
l The Federal Reserve Open Market Committee raised interest rates from 1% to 3% due to strong economic conditions and inflationary pressures
l Due to the lower liquidity in the Lightning Network, users are forced to pay higher fees to route payments, and the Lightning Network becomes more expensive
However, if the Lightning Network is liquid enough to apply the above logic, then the Lightning Network will be a huge success anyway.
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risk free return
In a sense, if the Lightning Network matures, one can consider the return on investment of running a Lightning Network node as the risk-free rate of return for Bitcoin, or at least the rate of return without credit risk. In traditional finance, this is typically the interest rate investors earn by holding government bonds, which are legally obliged to pay principal and coupons, and are also the holders of the creation of new money to pay the bonds, with near zero risk.
In theory, all other investments or loans in the economy should have a higher rate of return than this risk-free rate. The same is true for Bitcoin, where the rate of return for Lightning Network node liquidity providers can be seen as a benchmark rate within the Bitcoin ecosystem.
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in conclusion
in conclusion
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It remains to be seen whether professional hedge funds and venture capital investors will have the same enthusiasm for becoming Lightning Network liquidity providers as they did with PoS’s “stake-as-a-service” business model in mid-2018. While the return on investment offered for Lightning liquidity providers may not seem dramatic, we do see potential merit in this business model as the network is in its formative stages.
In our opinion, the Lightning Network could easily scale to many times the size of current Bitcoin on-chain transactions with purely hobbyist-based liquidity providers alone, without encountering any economic fee market cycles or issues.
