Lightning 101 For Exchanges: Overview

There are approximately 240 cryptocurrency exchanges in the world with some exchanges clearing hundreds of millions of dollars in transactions on a daily basis and others only trading in the thousands of dollars per day. On any given month, some exchanges might be shutting down with new ones starting up to replace them.

We will be publishing a series of posts about the implications of the Lightning network for exchanges. We will explore some of the challenges faced by crypto exchanges and how Lighting can help solve some of the issues, present new opportunities and even some situations where it may present challenges, in helping cryptocurrency exchanges evolve and grow to better serve customers.

Here are some of the topics we will cover related to Lightning in the Lightning for Exchanges series:

Security

From hacks to “shitcoins”, the crypto world is sometimes its own worst enemy. Many losses of customer funds via hacking occur because the exchanges act as custodians for the customer — holding their cryptocurrencies on their behalf. With Lightning, exchanges can still provide valuable services to their customers while offering greater security and customer protections.

An important feature of Lightning is it allows customers to easily withdraw, or deposit, funds into their account with an exchange. We have written extensively about security on the Lightning Network previously. What is important to understand is that Lightning has a different security model than bitcoin. It uses the bitcoin blockchain’s security properties in a clever way to make Lightning payments secure in a trustless environment.

Revenue & Efficiency

Arthur Hayes, CEO and Co-Founder of Bitmex, once said “traders want to trade”. Lightning can empower exchanges and traders with highly efficient and fast trade execution while not compromising on security and privacy. This will enable arbitrage opportunities as well as better price discovery as traders will be able to quickly capture opportunities across exchanges.

For example, at the time of this writing, Bitcoin is trading at $3929.10 on Bitfinex, $3828.25 on Coinbase and $3828.77 on Gemini. If we add other internationally based exchanges, the disparities increase (e.g. Bitcoin $3838.02 on Binance). However, since funds are held in custody and trades have to be verified on chain, the time delay makes it difficult to take advantage of these pricing discrepancies. The result is investors become locked in to a single exchange with inefficient markets, unable to secure best price available.

Exchanges that adopt Lightning will also discover new revenue opportunities. As crypto exchanges explore ways to leverage their data for new products and services, Lightning is an ideal solution as it provides speed, scalability, and privacy. Lighting technology also presents opportunities to customize data offerings thru micro-pricing, not currently available to traditional exchanges.

We will also explore ways Lightning will create more opportunities for cryptocurrencies through synthetic assets. These financial instruments allow traders to hedge their investment exposure and companies — some who may be considering accepting crypto payments — a way to mitigate their risks in ways unavailable in current models.

Regulation & Compliance

Lightning technology can help with some of the challenging Securities Exchange Commission issues around traditional exchange API data pricing and rules requiring brokers offer “best price”. In future posts, we will examine some of the controversy surrounding how traditional securities exchanges (NASDAQ, NYSE, AMEX, etc. ) provide and charge for data, its impact on the securities market and how crypto exchanges can avoid some of this by integrating Lightning.

We will also examine some of the challenges Lightning presents in light of Know-Your-Customer (KYC) and Anti-Money Laundering (AML) regulations. Lightning’s privacy benefits run counter to how exchanges must comply with securities law and regulations.

It is important to understand Lightning’s privacy model differs from typical blockchains in some fundamental ways. We have written about this extensively in our Lightning 101: Privacy article. Without repeating that post in its entirety, what Lightning broadcasts to the blockchain is more limited and harder to identify who is transacting what on the network. Thus, adding an additional layer of security and privacy for users.

Lightning for Exchanges Series

1. Overview
2. Regulation Part 1 — Money Transmitter Rules
3. Regulation Part 2 — Money Transmitter Rules
4. Security Part 1 — Overview
5. Security Part 2 – Backing Up Your Lightning Wallet
6. Security Part 3 – Private Key Management
7. User Experience – Liquidity
8. Managing Fees With Lightning
9. Routing Nodes
10. Conclusion