The Lightning Network has generated a lot of hype over the past couple of years because it enables fast, cheap Bitcoin transactions without sacrificing too much censorship resistance and decentralization. Instead of simply increasing the base block size limit back in 2017, Segregated Witness (SegWit) was added to Bitcoin to better support these sorts of layer-two protocol layers without sacrificing the crypto asset’s core value proposition.
This makes using Bitcoin for payments a far better experience. But hardly anyone wants to make payments with Bitcoin. They just want to hold. Due to a variety of issues regarding price volatility, tax implications, and general usability, the two main use cases of Bitcoin are still storing value and speculation at the moment.
That’s why the Liquid sidechain, which is a sidechain focused on transactions between exchanges, is a much more relevant project in 2020.
Removing Exchange Activity from the Base Bitcoin Blockchain
According to Chainalysis data from last year, 90% of Bitcoin activity is related to exchanges. If these coins are going through centralized, regulated entities anyway, then there is no reason to use the costly (relatively speaking) base Bitcoin blockchain for these transactions. If someone is moving coins from Binance to Coinbase, for example, there’s no reason for those coins to be put on a decentralized ledger. The user is already trusting both entities with their money.
As the above chart indicates, adoption of both Liquid and the Lightning Network (excluding private channels) is still extremely low, as there’s only around 1,500 Bitcoin (roughly $12.75 million) currently pegged into these upper-layer networks. It’s important to realize, however, that Bitcoin has been operating in a relatively low-fee environment for a couple of years now. In a situation where the upcoming halving event causes a massive bull run and fees begin to reach levels not seen since late 2017, it’s possible that a large percentage of Bitcoin’s total supply will move over to the Liquid sidechain in an effort to gain access to lower fees and lessen the impact of trading on the base blockchain.
A similar effect has been seen with SegWit. Years after all of the fuss about the need for greater transaction capacity back in the mid-2010’s, adoption is still below 60%. Blockchain CEO Peter Smith recently stated that they’d only make SegWit integration a priority in a situation where Bitcoin fees rise substantially. It’s also worth remembering that things like better transaction fee estimation and batching were only integrated by wallets, exchanges, and other Bitcoin services at a large scale when fees previously rose to levels that became problematic for users.
Lightning May Eventually Be Useful for Exchanges Too
Of course, the Lightning Network (or at least technology similar to it) may still be useful for exchanges. That said, exchanges have a number of potential issues to work out when it comes to enabling deposits and withdrawals via the Lightning Network.
For example, larger transactions are unlikely to be made via the Lightning Network due to concerns regarding security and cost. On the Lightning Network, fees are based on a percentage of the value sent, which means on-chain (or Liquid) transactions are cheaper than Lightning payments after a certain threshold.
There are also concerns regarding how exchanges will handle liquidity and security, seeing as they’ll need to tie up a large amount of Bitcoin in an online Lightning channel in order for payments to be routed through the exchange.
Additionally, there are key improvements needed for the Lightning Network’s payments layer to work more efficiently and integrate better with exchanges. Many of these concerns were discussed during panels at Bitcoin 2019 and The Lightning Conference.
There’s nothing stopping Liquid and the Lightning Network from being used together. In fact, the team behind the c-lightning software introduced experimental support for this functionality last summer. One of the key benefits of this combination of these two technologies is to enable instant atomic swaps between the base Bitcoin blockchain and the Liquid sidechain.
The differences between Liquid and the Lightning Network are a great example of Bitcoin’s multi-layered approach to scaling. But this game plan only works if people actually opt into upper-layer networks when they make sense. If the Bitcoin blockchain becomes clogged in 2020, it may be Liquid, not Lightning, that is able to alleviate that congestion.