We have written previously about the advantages Lightning gives exchanges and their customers. In particular; lower fees, faster transactions, and additional security. In this post we want to discuss why crypto exchanges should consider operating a routing node on the Lightning Network and what it could mean for their business.
- 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
Lightning nodes perform two services: monitor the underlying blockchain and manage interactions with other nodes. For more detailed information about Lightning nodes and how they work, check out this post (insert nodes post). Also, check out Alex Bosworth’s video from Chaincode Labs about routing and channel management.
Why Exchanges Should Be Routing Nodes
Exchanges are massive hubs of cryptocurrency activity. Millions of dollars flow into and out of their platforms every day. This puts them in a position to create orders of magnitude of liquidity on the Lightning Network. There are some tangible benefits to exchanges that manage and operate routing nodes on the Lightning Network.
Exchanges managing and operating routing nodes can earn revenue from fees paid by routing transactions along the Lightning Network. Given the large footprint of exchanges in the cryptocurrency ecosystem, they could potentially route a large volume of transactions on a daily basis. This could result in significant routing fees generated.
Node operators can charge a base fee for routing these transactions. They can change this fee for every transaction they route. Further, exchanges can set this fee to whatever they wish. While the median fee rate is currently, $.0000001, there is nothing preventing an exchange from setting a fee of $.10, $1.00, $100 or more. People may be willing to pay a premium for a node that has a proven history of routing and consistency of performance. Of course, the economics of the Lightning Network likely make it advantageous to keep fees low since high fees are a disincentive to transactions.
This fee is also flexible. Exchanges can modify routing fees to suit their business needs; lowering or raising them as market conditions evolve. Again, this “liquidity premium” would not be immune from the economics of a mature and robust Lightning Network where there would be thousands of nodes creating liquidity and routing transactions. The fundamental point remains the same; cryptocurrency exchanges can generate new revenue by routing transactions across the network.
The ability to collect fees could prove to be particularly useful – if not outright necessary – since exchanges will have to carefully manage their capital requirements to maintain liquidity in their channels. It’s difficult to predict what the capital requirements might be for a node routing transactions at this early stage of the network, but it isn’t hard to imagine a scenario where routing fees are collected in relation to liquidity requirements as well as some buffer to manage channel balances.
This liquidity requirement can actually be an advantage for an exchange. Lightning integration can offer incredible speed for traders for withdrawals and deposits. For such an integration to be useful for traders, it has to be reliable. In the context of the Lightning Network, this means securing access to liquidity in channels. An exchange that invests resources into becoming a routing hub on the Lightning Network gets the added benefit of having large volumes of money flowing through their node. These funds can be used to shuffle channel balances around, making sure that traders can deposit and withdraw funds at all times. In this way becoming a routing hub has synergistic effects, where routing enables greater liquidity for withdrawals and deposits, and withdrawals and deposits generate routing fees.
Lastly, as discussed previously in our regulatory posts (Part 1 and Part 2) an exchange can always choose to simply not operate a routing node if they are concerned with violating federal or state money transmitter laws. Although we argue Lightning node operators should not be considered traditional money transmitters, it is an evolving policy issue.
There are compelling reasons why a cryptocurrency exchange should consider operating a routing node on the Lightning Network. It can be a source of new revenue as it routes transactions, which could be hundreds of thousands per day or more as the network grows. In addition, the funds generated from routing can in turn be used to maintain highly liquid channels for traders to make fast and easy deposits and withdrawals. Exchanges that start exploring and learning how to operate and manage a routing node now stand to benefit the most as the Lightning Network grows.
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: