Depth | BitMEX Research Report: Incentives and Investment Value of BTC Lightning Network

The BitMEX research team has previously conducted in-depth research on lightning networks. Now, as the lightning network moves from abstraction to experimentation, they revisit this hot spot.

The focus of this report is to analyze lightning networks from the perspective of finance and investment, especially the charges of lightning network providers and their associated incentives, which are less relevant to the technical level.

Through research on the market dynamics of lightning network routing fees and the provision of liquidity financial incentives for lightning node operators, we found that the equilibrium relationship between routing fees and return on investment is a major challenge for current lightning networks.

The expansion of the lightning network and the wider financial environment changes will affect the market performance of lightning network rates. In the long run, competition between nodes will be the main driver of price.

User and liquidity provider balance

Critics of Lightning Networks often point out that routing is a major issue and calls it "an unresolved computer science problem." We do not fully agree with this qualitative.

However, we do believe that the dynamic balance between liquidity provision and the financial and economic aspects of payment routing is its main challenge.

Lightning network operators need to be motivated by routing fees to provide sufficient liquidity for the payment to proceed smoothly.

Mobility needs to be clearly assigned to the channels that are in demand, and identifying them can be challenging, especially when new businesses enter the network.

Ensuring that the network is low-cost for users, and ensuring that fees are high enough to motivate liquidity providers, there is a delicate balance between the two. But from another perspective, the market clearing rate may also depend on the economic environment.

Lightning network routing fee composition

For BTC transactions on the chain, the user has the right to price the transaction fee for each transaction at the time of payment. The miner generates blocks by selecting transactions with higher commissions to maximize revenue.

But Lightning Networks is currently operating in another way. Routing node operators set commissions, and users select paths and channels for their payments to minimize commissions.

It can be seen that the lightning network was originally set by the supplier, not the user. Therefore, Lightning Network provides a superior charging architecture. Because the supplier provides a specialized service, and the competition between the suppliers (rather than the ordinary users) is more appropriate and the operation is more convenient.

In lightning networks, there are two types of routing fees, base fees and rates.

Two lightning network fees:

Inbound and outbound

In order to provide liquidity for routing payments and earn fee income, Lightning Node operators need to lock funds (BTC) within the payment channel.

Two channel capacities:

Graphical illustration of channel inbound and outbound capacity:

Source: BTC Lightning Wallet; orange balance is inbound capacity, blue balance is outbound capacity

How to become a successful routing node?

To be a successful routing node is harder than you think. As of this writing, there are currently 7,615 public lightning nodes based on data. However, in terms of managing nodes, rebalancing channels, and setting fees in an appropriate manner, only a few hundred nodes do a good job of providing liquidity.

The node runner may need to:

  • Adjust rates and base fees, monitor the impact of adjustments, and calibrate for optimal revenue maximization settings;
  • Analyze the network and look for lightning nodes with high payment requirements and poor connectivity, such as new merchants;
  • Analyze the fee market, not only for the overall network, but also for high-demand, low-capacity paths that are being targeted;
  • Continuously monitor and rebalance your channels to ensure adequate two-way mobility;
  • Implement a customized backup solution for the latest channel state to protect funds when a node computer crashes;

At present, there is no automated system capable of implementing the above functions. If this does not change, it may be necessary to set up a dedicated business to provide liquidity for the lightning network.

However, as with liquidity, the challenge of overcoming these technical issues does not necessarily mean that payments will become very difficult or expensive. Instead, these technical challenges can adjust the equilibrium market rate.

The more difficult it is to solve these problems, the greater the incentives, and the higher the potential return on investment that channel operators receive. So dominantly, the success of the lightning network will be demand, not the challenges faced by node operators.

In order for the lightning commission market to operate effectively, the node operator may need to adjust the commission based on the competitive landscape, which may be based on an algorithm or a manual process with the goal of maximizing fee income.

In order to simulate the standard practices that may eventually form, the BitMEX research team conducted a three-month trial.

Rate test research method

Although the Lightning Network is currently in a new state, the BitMEX research team decided to conduct a basic test to test and evaluate the status of the fee market. We built a lightning node and periodically modified the rates to try to determine which rates would maximize the fee income.

The scatter plot below shows how basic non-scientific analysis can be performed through a single node. It shows that the current rate does have an impact on the fee income of the lightning node.

When the rate increased from 0 to about 0.1 per thousand, the daily fee income showed a sharp acceleration. However, once the fee is raised above this rate, the average daily fee income shows a gradual decline. Therefore, according to this trial, the rate of income maximization is about 0.1%, which is undoubtedly very low compared to other payment systems. Of course, this is only a fee for a hop, and a payment may have multiple hops.

At present, the lightning network fee market is almost non-existent, and the BitMEX research team may be one of the few lightning nodes to test the economic income maximization behavior by changing the fee.

Once the network is scaled up and other participants try to maximize revenue, the market for the fee market can change a lot. Therefore, this operation can only be regarded as an illustrative test, not a specific disclosure of the lightning fee market.

Lightning node daily fee income and rate comparison:

Source: BitMEX Research Team

Remarks on the lightning fee income data graph:

  • Daily data from December 31, 2018 to March 24, 2019;
  • The data comes from a lightning node;
  • The base fee for the entire period is 0;
  • The return on investment data does not include the BTC transaction fee on the chain. When including the impact of fees, all groups except the optimal rate will show a negative return on investment;
  • Data includes weekdays and weekends. In general, lightning network traffic is much lower on weekends;
  • Rates are changed daily around 21:00 UTC. Decrease the rate every day, jump to the top of the rate range after a few days of downgrade, and then start the next rate reduction cycle. This is because some wallets don't check the rate each time they try to provide a path for the payment through the node, so many payments will fail when the rate is raised;
  • Manually rebalance the channel every two weeks. It takes about 30 minutes each time;
  • The lightning node runs the LND, and the software connects to the host every two weeks to update it;
  • About 30% of the channels (by value) are open with Autopilot and the remaining 70% are manually open;
  • The return on investment is calculated by using the network's daily outbound channel capacity, annualizing the return on investment based on daily fee income, and then calculating a simple average based on all days of a rate in a particular interval;
  • The data is based only on one node and the channel set specific to that node, and the experience of other node operators may vary greatly;
  • We have tried to test with public nodes, but the fee income is too scattered and the data is not reliable;
  • With the development of the network, the faster the circulation of market transactions, the linear scale may be more appropriate.

Reasonable return on investment

In addition to daily fee income, you can also consider the annualized return on investment associated with running a lightning node and various rates. This return on investment is calculated by annualizing the daily fee income and then dividing by daily outbound liquidity.

The highest annualized investment return achieved in the trial was 2.75%, while the highest commission group investment return was approximately 1%. For an investment theory that should theoretically be relatively low risk, this seems to be a reasonably attractive return, at least the ability to back up the lightning channel in real time is implemented.

Existing BTC investors may be attracted by these returns to provide liquidity to the lightning network. Alternatively, a dollar-based investor may also buy BTC, leverage leverage to hedge BTC price risk, and then attempt to earn lightning net fee income.

Annualized return on investment of lightning nodes in different fee groups:

Source: BitMEX Research Team

Of course, these return on investment may not be able to motivate liquidity providers in the current lightning network. Current node operators may be amateurs, and most of the node operators are losing money when considering the chain charges required to open and rebalance the lightning path.

While this amateur-based mobility can sustain a network for some time, in order to meet the massive scale requirements of Lightning Networks, a potential return on investment is needed to attract investors.

External macroeconomic assumption

In the current low-yield environment, a 1% return on investment may seem attractive, but Lightning Networks may initially be difficult to attract suitable commercial liquidity providers, and investors in this sector generally seek high-risk, high-reward investment. Therefore a new investor category may be required.

If the lightning network reaches a large scale, such a stable, low-risk return, highly mobile investment product will be more sensitive to the economic environment.

Consider the following scenario:

  • The Fed’s base interest rate is 1.0%.
  • Lightning node operators typically earn a 1.5% annualized return on investment for their outbound balance.
  • Due to the strong economic environment and inflationary pressures, the Federal Reserve Open Market Committee raised the interest rate from 1% to 3%.
  • As the return on investment is more attractive, Lightning Network node operators withdraw funds from the Lightning Network and buy government bonds.
  • Lightning networks will become more expensive due to the reduced mobility in the lightning network and the need for users to pay higher fees.

However, if the lightning network mobility is large enough to fit the above logic, the lightning network is already an amazing success.

Benchmark interest rate within the BTC ecosystem

To a certain extent, if the lightning network matures, investors can even consider the return on investment running the lightning node as the risk-free rate of return of BTC, or at least the rate of return without credit risk.

In traditional finance, this is usually the rate of return earned by investors holding government bonds, where the government has a statutory obligation to pay the principal and coupons and a means of creating new funds to pay the bondholders, so the risk is close to zero. In theory, all other investment projects or loans in the economy have a higher return than it.

The same theory applies to BTC, and the return rate of the lightning node liquidity provider can be considered as the benchmark interest rate within the BTC ecosystem.

In the future, if many of the challenges involved in running a node have been overcome and there is a competitive fee setting algorithm, the risk-free rate of return for this lightning network may ultimately be determined by:

  • Macro financial market environment – the higher the interest rate, the higher the risk-free rate of return of the lightning network;
  • The need for lightning network transactions—increased demand or faster capital flows—can increase the risk-free return of Lightning Networks.

Waiting for more liquidity to join

Will professional hedge funds and venture capital investors behave the same as the “staking as a service” business model of the Prosperity Proof (PoS) system in 2018? Enthusiasm remains to be seen.

Although the return on investment of lightning network liquidity providers is not very attractive at present, we are indeed seeing the potential advantages of this business model as the network is in its formation stage.

We believe that Lightning Network can easily reach the multiple times of BTC's current chain trading volume without encountering any economical fee market cycle, and everything is simply based on amateur liquidity providers.

However, if the network is to reach the scale that many lightning network advocates want, it will need to attract investors who are eager to maximize revenue to increase liquidity. As the investment environment changes, the network's fee market conditions may also change significantly.

It is relatively easy to build nodes, provide liquidity, and earn fee income by reducing the income of your peers. It is not known how the operating channel of the operating node, the degree of liquidity provision, and the return on investment will be balanced. But according to the architecture and design of the lightning network, we believe that the system will be more user-oriented and low-cost, rather than liquidity providers.


Sonny Sun typesetting

Source: Encrypted Valley

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