Will the Lightning Network be good for the future of Bitcoin?

tl;dr

The Lightning Network will not be good for the future of Bitcoin, all things considered.

• The arbitrary block size constraints placed on the network by a small faction of stakeholders cause market distortions similar to a central bank’s ability to pick winners and losers in an economy.
• Metcalfe’s law is a powerful indicator of what is happening now and what is driving the future of networks.
• Censorship-resistancy on the Bitcoin network is headed in the wrong direction.

/tl;dr

This article is written in preparation for a debate. I wish to distill my argument so that the other side will be able to “steel man” my position.

In the interest of “F-type readers” (those that read the first two paragraphs and then skim the rest), I’ll start with my strongest stuff. Should you challenge my assumptions, please read the whole article. You might also consider reading the parts in bold text.

Any logical decoupling of a derivative from its underlying asset will, necessarily, cause an existential risk for the underlying asset. Given enough time, it is a certainty that the underlying asset will become completely orthogonal to its derivative. — my informal corollary

The above corollary, combined with Gresham’s Law, ensures that the underlying asset will be driven out of the economy.

I am not trained as an economist or historian, but it is easy for me to recognize a pattern that has repeated itself over and over. The best example is paper money itself. The slips of paper we now carry as currency started out as receipts for gold specie. Over time, the link between the two fell away and, eventually, disappeared all together. This was no accident nor was it a grand conspiracy. This is the logical path of technology. Paper money was a technological advancement to solve a problem. All derivatives used as stand-ins for mediums of exchange will undergo this path. Once users accept the derivative, it is terribly inefficient to keep the underlying around. This can and will happen to Bitcoin, facilitated by the use of the Lightning Network (hereby referred to as LN).

Of course, I am not saying new technologies shouldn’t be deployed, even if they are certain to be a liability to the network’s future. In fact, I am saying quite the opposite, MORE experiments should be given the chance to flourish on Bitcoin’s network. I have a Thomas Jefferson-like confidence in my fellow man. I know the market will reject the bad ideas, eventually. But this is not the situation on the Bitcoin network right now.

Let’s unpack the current state of things in Bitcoin’s infrastructure. I will make every effort to avoid attributing motivation to any people involved. I can never know what’s in another person’s heart. I can only report on the actions of other people. So, let’s talk about the actions. I will, however, make presuppositions about the motivations of companies. It is perfectly logical to assume that companies and investors want a return on their investment. I’ll be leveraging this fact in my arguments.

Currently, a small group, mostly affiliated with one company in Silicon Valley, dictate what ideas can and cannot be tried on the network branded “Bitcoin”. Any competing software implementation that does not toe the company line will be viciously attacked and labeled “an alt coin”. Because precedent has dictated that the name “Bitcoin” refers a particular software implementation under the control of a few people. Bitcoin has a centralized governance structure. Please see the last paragraph regarding how this precedent was set.

But how can this happen in a “decentralized network” such as Bitcoin? Wasn’t the whole idea to have money where no one was in charge and no one can censor the free exchange of value? Yes! This was the original idea, but where Satoshi Nakamoto effectively solved the double-spend problem, he made no in-roads into the governance problem. He made no technical innovations to prevent investment banking from bribing software developers into doing their bidding.

We now know that a network’s value is proportionally much greater than the sum of its users. This is in accordance with Metcalfe’s Law. We see the effects of this statement all around us. Facebook, Twitter, Wechat. They are all enormously valuable because they have very large networks of users. Their growth compared to competitors is also nonlinear. The more users they get, the more users they are likely to get in the future. We have a positive feedback loop. This is the Network Effect and this is why investment capital piles into Facebook and not into competitors. The same goes for payment networks like Bitcoin. Why is Bitcoin so much more valuable than its competitors? Because it has the most liquidity. Why does it have the most liquidity? Because more people trade it. Why do more people trade it? Because it has the most liquidity…and so on and so on. So, it’s the users, in aggregate, that make Bitcoin valuable and users come to Bitcoin because it has the most users. And Bitcoin is a name applied by the community, by convention and precedent, to a single network based on a single software program released by a few individuals that are directly and solely compensated by Wall Street investors.

It should be clear what the goal is for any company interested in making a return on investment. Get the users and monetize them as quickly as possible before someone else does. Not only that, but ensure the new network has the Network Effect. Enter the LN.

If one were to undertake the task of capturing the most users as quickly as possible, it should be obvious that one can’t simply compete with networks that have the Network Effect directly. So why not just buy Bitcoin like Facebook did with Instagram? Bitcoin is not a company, so this won’t work. Further, Bitcoin’s consensus mechanism (Proof of work) makes a full network takeover nearly impossible given the state of manufacturing and finance. You are unable to make small, incremental and palatable changes to prevent catastrophic failure of the current Bitcoin network. Here is phase 1 of the plan:

Step 1: Fund a company that has the keys to the software development.

Step 2: Build new product(s)/network(s).

Step 3: Patent the technology to harness the force of government to protect the investment.

Step 4: Push all of Bitcoin’s users to the patented network by making the original network functionally unusable for almost all of Bitcoin’s current users.

This is a carrot and stick approach (silver or lead, if you prefer). Entice users with fast, cheap and convenient transactions. If the users don’t go, constrain block space so that Bitcoin transaction fees are so high that over 50% of all unspent transaction outputs are completely unspendable.

Once you move all of the users to the LN, you now have the Network Effect.

Begin phase 2 of the plan.

Step 1: Vanquish all of your competitors by instituting regulations that make it impossible to enter the market.

Step 2: Capitalize on your investment.

But what if competitors come in with larger bribes for the government regulators?

No problem, you still retain the keys to the original network.

Step 3: Use the power to change the network through soft-forks to filter out your competitors.

Step 4: Profit further.

But, where does that leave Bitcoin’s original network? The link between the layer 2 networks and Bitcoin’s original network is living on borrowed time. This time should be considered the time it takes for the LN users to acclimate to the new network and realize it is a functional stand-in for the real thing.

You may be thinking, “you’ve just jumped to the assumption that just because a user moves to the LN, the user will now be under the direct control of the people underwriting that network’s development”. To this I say, yes, I’ve certainly hand-waved over a crucial piece of my argument. So, I’ve made my argument in a separate Medium article. I felt that adding them here would vector too far off from the main points. For the rest of the article, we will assume that you are familiar with my reasons why the LN itself captures users.

After the LN breaks ties with Bitcoin, it will be just a name and resemble nothing of the network we have today. It will have a few users like Peter Schiff types that wax nostalgia about when users will all come back.

At this point, the layer 2 network operators, like the LN creators, get to set the rules of who uses your network and at what price. Very convenient and massively profitable! All this is akin to creating the Federal Reserve Bank and the payment rails (Visa, Mastercard) at the same time and single-handedly reaping the profits from it all, in perpetuity, and without having to share it with anyone else. It is the best deal in Silicon Valley, bar none.

If this is such a good idea, why isn’t anyone else making this play? Funny you should ask, they are and in a big way! Bakkt, which is unabashedly connected to the most powerful interests on Wall Street is desperately attempting to launch as we speak. But this is just the continuation of a long line of bankers attempting to capture cryptocurrency networks. Bakkt is late to the party, so they must compete with other interests on their competitor’s terms. This competition for users on the second tier networks will be touted as good for Bitcoin users, but as I’ve shown earlier in this article, it is just a ruse.

So, where are we right now? As always, this is a good news/bad news situation. The good news is that some Bitcoin users see through the smoke screen and are leaving the Bitcoin for good, presumably for other cryptocurrencies. The bad news is that for every user that leaves the network there is net negative marginal effect on the entire cryptocurrency space. The negative effect on Bitcoin greatly outweighs the positive effect on the target crypto, at least in the short to medium term. Metcalfe’s Law should tell us why. If Bitcoin bleeds enough users to a single crypto, the negative effects will decay to zero. Unfortunately, this metric is very difficult to independently quantify. Ultimately, supporters of the entire cryptocurrency space are in a lose/lose scenario until a) Bitcoin can attract more users faster than all other cryptocurrencies. This is unlikely due to plan to convert users to alternate networks. And b) enough users leave Bitcoin so that another currency can gain the Network Effect. If this happens, the return on investment of the LN will be greatly diminished and the probability of future dominance will fall below 50%.

Finally, it should be clear that the LN (or any second tier network) in the presence of an artificially constrained main network, is really bad for Bitcoin and bad for the space as a whole. The Scaling Wars of 2017 yielded a result that set the precedent for the proliferation of networks and their users. This result is super bad for all sides except for those wishing to see the demise of cryptocurrencies. The winning side in the war was willing to take the hit because they are willing to take a huge risk. Their gambit is: can they can get enough users moved over to the LN and still retain the Network Effect in the cryptocurrency space? All things being relative, if users leave the cryptocurrency space entirely, this doesn’t matter to them so long as they retain the numbers relative to other cryptos, especially compared to other top cryptos. The only way this plan can fail for them is if another top cryptocurrency manages to gain the top spot in terms of users. At this point in time, this is very unlikely. Ultimately, this is a bad plan for Bitcoin and its users.