BitMEX Research recently published an extensive analysis of the financial and economic components of Bitcoin’s Lightning Network (LN) designed to shed light on the fee economy of the experimental layer two scaling network. Their evaluation reveals some intriguing prospects for the LN, and how its long-term potential can be driven by a low barrier to entry — leading to an ecosystem fuelled by competition, low fees, and a user-centric model.
The report also highlights specific aspects of the LN that remain major hurdles for it to reach its full potential, specifically the persistent problem of imperfect mesh network routing. However, BitMEX projects an overall favorable view of Bitcoin’s LN and its potential to become a viable ecosystem of economic participants that can help Bitcoin scale substantially.
Routing and The LN Fee Market
The routing issue of mesh networks is often cited by critics of Bitcoin’s LN as a significant problem in computer science. However, BitMEX identifies that the problem is not in the routing protocol but more in the liquidity issues that arise from a P2P, bidirectional payment network where node operators are required to provide liquidity. Without node operators injecting liquidity via their own nodes, transaction routing over the mesh network is inconsistent — a problem for a payments network.
In the context of LN fees, the high-level flow of transactions draws from a model where node operators set the fees and users select the transaction path with the lowest fees. BitMEX details how such a dynamic may be a positive development in the fee structure of the network compared to Bitcoin’s on-chain fee market where users set the fee directly. The liquidity provider fee structure of the LN enables a more competitive system based on the supplier rather than directly on the user.
Node Operator Liquidity
Node operators supply liquidity to Bitcoin’s LN by investing their own capital (BTC) into payment channels on their node. Investment capital of node operators consists of their outbound capacity which are funds that will be returned to the operator should he/she decide to close their payment channels. Outbound funds can be collected via fees from routing payments, opening payment channels with other nodes, and receiving funds directly from other nodes.
According to BitcoinVisuals, there are more than 4,000 Bitcoin LN nodes with open channels and nearly 36k unique channels on the network. However, BitMEX states that it is likely only a few hundred nodes are currently functioning as impactful liquidity providers on the network.
Operating a node as a liquidity provider requires a relatively in-depth understanding on the LN, including how to rebalance channels, manage the node, and set fees appropriately. BitMEX cites how there is no automated service for managing nodes in such a capacity yet. While the growth of node providers like Casa has helped ease this burden noticeably, there is still much work to be done on familiarizing more mainstream users with node management in the young LN.
BitMEX goes on to detail how node operators will need to adjust their fee markets based on an evolving competitive landscape should the LN reach the level of adoption desired. They experimented with their own Bitcoin LN node for 3 months — modifying the fee rate to see what their results yielded.
Fee Market Experimentation Results
The results of BitMEX’s node fee experimentation revealed that the optimal revenue maximizing fee was roughly 0.1 bps, which is substantially below conventional payment rails. Any more increase in the fee rate resulted in a gradual decline in income received due to fewer users routing payments through the node. The 0.1 bps fee is only based on one ‘hop,’ however. A hop is when a payment jumps from one node to another, and complex or larger payments usually require multiple hops.
BitMEX notes that the fee market is still virtually non-existent on Bitcoin’s LN as they are likely only one of a few nodes to experiment with fee changes in a sizeable capacity.
An interesting takeaway from BitMEX’s analysis is their estimation that the peak annualized return on investment for operating a node as a liquidity provider is roughly 2.75 percent with the highest fee bucket investment return at 1 percent. Due to the low-risk investment of injecting capital into the LN, BitMEX cites that the attractive returns should push the fee market into a competitive landscape among users.
However, the LN will need to transition away from hobbyist liquidity providers and towards financially incentivized participation of liquidity injection by more users to reach its full potential.
Finally, BitMEX outlines how returns on investment as a node operator in the LN could potentially become Bitcoin’s risk-free rate of return. The LN fees could then become the base rate in the Bitcoin economy and could be affected by outside conditions such as demand for LN payments by merchants and interest rates in conventional financial markets.
Bitcoin’s LN is still in its experimental phase despite experiencing outsized growth over the last year. The fee market will play a crucial role in its future proliferation, but for now, is relegated to only a few liquidity providers and a high technical barrier. As the network grows, the fee market will change parallel with technological advancements in mesh routing and node management software.
BitMEX research consistently publishes some of the best analysis in the industry, and their examination of Bitcoin’s LN fee market presents some useful insights into a more obscure component of Bitcoin’s ecosystem once again.