Lightning 101 For Exchanges: Regulation Part 1

Money Transmitter Rules

First, we must baseline a few definitions. According to the Treasury Department’s Financial Crime’s Enforcement Network (FinCEN) a money transmitter is:

“[A] person that provides money transmission services, or any other person engaged in the transfer of funds. The term “money transmission services” means “the acceptance of currency, funds, or other value that substitutes for currency from one person and the transmission of currency, funds, or other value that substitutes for currency to another location or person by any means”

FinCEN details two types of actors they consider in their rules on who is or who is not a money transmitter. A user or an exchanger. Different rules and requirements apply depending on which definition applies to a person or entity.

1. A user is a person that obtains virtual currency to purchase goods or services.
2. An exchanger is a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency.

Essentially, if you are taking and holding someone else’s money for the purpose of buying other currencies, virtual or real, you are an exchanger and subject to money transmitter rules. The critical element is who controls the funds.

If Alice has her cryptocurrency held at an exchange and wishes to purchase something from Bob, she tells her exchange to send her money to Bob’s exchange who in turn will deposit the funds into his account. This is like any other bank transaction and is regulated as an exchanger.

It should be noted that U.S. based exchanges that have custodial relationships with clients and transmit money, e.g. Coinbase, Kraken, Bitstamp, are already required to comply with Anti-Money Laundering and Know Your Customer laws.

Enter the Lightning Network

On the Lightning Network, the individual user controls their money. This cannot be overstated. There could be a custodial relationship but it isn’t necessary. A person can send direct payment to another person or entity’s Lightning Node. It is like an onchain bitcoin transaction in the sense that once the transaction is published to the Bitcoin network it cannot be modified after the fact. It is always a valid transaction, it is just a matter whether a miner includes the transaction in a block. With Lightning, it is a matter of if a peer decides to route the payment (click here for more details on routing on Lightning Network). The payment itself will always be valid and impossible to modify after the fact. The person who is providing routing services cannot alter the transaction, only decide to route it or not to route it.

Imagine Alice wants to buy a coffee from Starbucks. No prior relationship ever needs to exist between Alice and Starbucks for her to pay Starbucks for her coffee. Alice’s Lightning Wallet need not even be connected to Starbucks’s Lightning Node to send the payment. Her payment could be routed through multiple channels — perhaps Bob’s or perhaps Bob and Carol before reaching Starbucks. To make it even more interesting, with Lightning, Bob and Carol would not even know Starbucks is the ultimate recipient of the payment. They are merely participating, or more accurately their nodes are participating, by routing fees throughout the network. Extending this scenario, Starbucks by virtue of operating their node, could be routing payments and providing liquidity to the overall network as well — routing transactions and payments to destinations they would not know ultimately to whom and even potentially the originator.

Coin Center, the leading U.S. based crypto policy group, uses the example of Craigslist to illustrate the difference between an actor that holds money and one which merely acts as a finder or connector for others:

“[T]he business merely helps individual buyers and sellers find and communicate with each other, then it is never “accepting and transmitting” tokens or bitcoins for its users, nor is it “buying or selling” tokens or bitcoins.”

What About Channels?

Let’s look at a scenario where a person opens a channel with another person or entity? Say for example that Alice opens a channel with Starbucks and keeps $100 in there to fund her coffee habit. All else being equal, that money is not in Starbucks’ custody. They do not hold any of the funds other than the funds she has paid to starbucks for her coffee. Aside from technical considerations or custom service offerings, Alice can remove her funds at her discretion.

What About Services?

At Suredbits, our customers can refund their remaining unused balances on any open subscription that has unused time. Moreover, this can be done automatically. If someone has a subscription to our trades channel for one of our exchanges for 60 seconds, they only pay per second of consumed data feed. If they chose after 30 seconds to end their subscription, the remaining 30 seconds is refunded to them immediately. Lightning enables this ability but is not the default state. We have made a business decision to offer this to our customers. We are not custodian’s of their money. This is a standard service transaction not subject to money transmitter rules.

Conclusion

Lightning and Lightning Network is a way to scale the decentralized benefits of Bitcoin’s peer-to-peer payment feature while implementing its own privacy and security scheme. People and entities that run and maintain nodes on the Lightning Network — which we do at Suredbits — are providing liquidity and routing for peer-to-peer payments as well as for our own business purposes.

Lightning should be embraced by crypto exchanges and regulators alike as a way to promote safe and private transactions. Those are critical public policy goals as well as preventing money laundering and financial malfeasance. In fact, Lightning should be viewed as a way to prevent some of the financial crimes that occur from exchange theft, like the unfortunate incident with the QuadrigaCX exchange.

Having said this, there is work to be done. The crypto industry policy group Coin Center has worked to help develop a uniform model state law for governing virtual currency businesses. The money transmitter issue is addressed in the model law and makes explicit that the rules should follow who has control of the money.