Over the past couple of months, we have put forth ideas on why cryptocurrency exchanges should consider adopting Lightning technology for their platforms. We have highlighted the benefits to both exchanges and their customers. But we have also attempted to address some of the challenges an exchange might encounter in adopting Lightning. In this post, we will summarize the key points and takeaways.
- Regulation Part 1 — Money Transmitter Rules
- Regulation Part 2 — Money Transmitter Rules
- Security Part 1 — Overview
- Security Part 2 – Backing Up Your Lightning Wallet
- Security Part 3 – Private Key Management
- User Experience – Liquidity
- Managing Fees With Lightning
- Routing Nodes
Our analysis focused primarily on Money Transmitter Rules under the Bank Secrecy Act. FinCEN has recently issued additional guidance on this matter. However, how FinCEN views Lightning nodes that route transactions along the broader Lightning Network, is not totally clear. Recent guidance from FinCEN was silent on how Lightning nodes are viewed or how they might be treated by the SEC. We believe strongly and argue that Lightning is the best way to realize the policy goals of consumer protection.
One of the key factors in determining duties of MTR is whether you are acting in a custodial capacity of someone else’s funds. Lightning requires no such custodial relationship. Node operators have little to no control over funds moving in and through their nodes. They typically have no idea the initial source of the transaction or who is the ultimate recipient.
Ultimately, U.S. exchanges are already registered and comply with all applicable federal regulatory bodies. An exchange could use Lightning just a method for their customers to deposit and withdraw funds. Given the current regulatory uncertainty, an exchange could simply choose not to route funds and avoid the risk running afoul of Money Transmitter regulations.
There are security challenges with the Lightning Network that is not present with traditional blockchain payments. Two of the most pressing issues is how to backup your wallet, and how to manage your private keys.
When it comes to backing up your wallet, the different Lightning implementations have their own systems that vary quite a bit. However, they all revolve around the same concept: You need regular backups of your data, and it also matters in what state your wallet was when the backup was made. If the wallet was backed up naively (without paying any attention to where in the process it is), loss of funds could occur. There’s also currently limits to which funds can be recovered by using a backup. However, backup technology for Lightning is a point of active research, and likely something that will improve in the future.
In a similar vein as managing backups, managing private keys is not as straightforward as regular blockchain keys either. Currently keys cannot be kept in cold storage while being used on the Lightning Network. This is partially because no one has implemented such a solution, but also partially because Lightning is a far more interactive protocol than Bitcoin. For example when routing transactions, you need your private key accessible in a short timeframe at all times, something which doesn’t line up with how a traditional hardware wallet functions.
There are real benefits to the user experience for crypto exchanges that adopt Lightning technology. Making it easier to make withdrawals and deposits will make an exchange more competitive and profitable. With Lightning, crypto exchanges can reduce on-chain transactions times from 10 to 30 minutes to potentially milliseconds on the Lightning Network. This not only provides a better user experience but also will likely lead to more trading volume and activity as traders can move in and out of positions with no custodial risk.
Lightning can fundamentally change the way crypto exchanges manage fees for withdrawals and deposits. We know from history that on-chain fees will increase with more activity. From May 9th to this writing, on-chain fees have increased roughly 323%. More importantly, fees on the Lightning Network are reliably less expensive. As of this writing, next block fees are roughly $4.32. You pay that regardless of how much you withdraw. With Lightning, had you withdrawn $1,000 it comes out to roughly a $.001 fee. Had you withdrawn $1 million, the fee would have been approximately $.99.
Finally, we explore why crypto exchanges may want to be a routing node on the Lightning Network. First, routing could be a potential source of new revenue as each transaction routed generates a fee for the routing node. Given the potential high-volume activity of a crypto exchange, these fees could be significant. These fees, however, could also help an exchange maintain liquidity in their channel balances to ensure their investors are always able to deposit and withdraw funds as necessary. The more deposits and withdrawals are made, the more fees generated. Thus, creating a virtuous cycle.
Lightning fixes multiple problems that exchange’s are facing today. It lowers transaction fees for itself and its users, it provides a way better user experience, and offers new opportunities for generating revenue.
In the abstract, Lightning is a great improvement for the entire blockchain ecosystem. Transacting onchain is slow and cumbersome, while transacting with Lightning is quick and easy. This UX improvement will unlock new applications for cryptocurrency that grows the entire market.
Exchanges play the most important role in the cryptocurrency economy today. Most economic activity involves moving cryptocurrency through exchanges. This means exchanges are in a unique position to influence adoption of new technologies like Lightning. We ask that you adopt this technology not only to make your business more profitable, but to further the adoption of bitcoin.
If you are an exchange or interested in what Lightning can do for you and your business, contact us at [email protected].
You can also reach us on the Lightning Network: