The Lightning Network can help Bitcoin scale by enabling more payments to be made in a fast, cheap, and reliable way. However, developers are working to take this payments network far beyond coffee purchases and microtransactions.
Eventually, you will be able to use Lightning to peg the value of your Bitcoin to real-world assets. Multiple companies are trying to turn this idea into a reality, although it’s unclear how decentralized these solutions will be.
The basic idea is that you would be able to effectively hold U.S. dollars, gold, or Apple stock on the Lightning Network by way of Bitcoin held in a multisignature address. This would allow the user to hold derivatives — a kind of asset whose price is based on the value of a different asset — in a potentially censorship and seizure-resistant manner.
So rather than, for example, owning $100 in Bitcoin, a user could hold $100 in gold via a Bitcoin-based derivative that gives them access to the returns from holding gold in a relatively permissionless manner (though third party trust still exists in the form of a price oracle). Bitcoin’s short-term price volatility is one of the reasons the cryptocurrency has yet to gain greater levels of adoption among the general public, so allowing for exposure to more stable assets could be an improved sales pitch to the average person.
This sort of functionality has already existed on Bitcoin’s base blockchain (this is how Abra used to work) and is also popular among various decentralized-finance (DeFi) applications on Ethereum (see MakerDAO and Synthetix). The way these projects work can differ, but they ultimately require users to lock up some amount of Bitcoin, Ether, or another cryptocurrency in a multisig address or smart contract. A price oracle or set of price oracles is then used to peg the user’s cryptocurrency to the value of a real-world asset. An oracle is basically a third party that brings real-world data, such as the price of gold or the result of a sporting event, into a cryptocurrency network.
One of the methods by which these sorts of derivatives could come to the Lightning Network is Discreet Log Contracts (DLCs). DLCs are a way to bring outside information into cryptocurrency networks while limiting the known issues around scalability, privacy, and trust. Tadge Dryja of MIT’s Digital Currency Initiative gave a talk on DLCs and how they can work on the Lightning Network more than two years ago; however, this functionality is still not available for the everyday user.
SuredBits is one of the companies currently looking at how DLCs can be useful to Lightning Network users.
“I think a lot of people are looking at them right now for doing disintermediated (non-custodial) financial contracts,” SuredBits’s Nadav Kohen told LongHash. “Though, I imagine other use cases would also be natural (betting, rainbow network channels, probably other stuff). And I think eventually DLC oracles will be integrated with escrow contracts to increase privacy.”
To Kohen’s point, DLCs can be used to hedge the value of one’s Bitcoin holdings to any real-world event, not just assets. This means derivatives built on the results of sporting events, tomorrow’s weather, or any other activity in the real world are also possible.
From a Bitcoin wallet perspective, it would be possible to hedge users’ Lightning Bitcoin to the local fiat currency by default, improving the user friendliness of a spending wallet while also avoiding the potential tax implications of spending a volatile cryptocurrency on a cup of coffee every morning.
Abra appeared to be working on this sort of functionality, but according to CEO Bill Barhydt, the mobile cryptocurrency wallet currently has other priorities to focus on right now. Additionally, Abra is no longer built on the "synthetic assets" model, opting for native cryptocurrency integrations rather than Bitcoin-based derivatives due to a combination of regulatory and cost-related factors.
Far From Perfect
It should be noted that hedging on the Lightning Network (and all other cryptocurrency networks) is rather limited from a censorship resistance perspective due to the oracle problem — that is, bringing real-world information into a cryptocurrency network in a trustless and censorship-resistant manner. If the price oracles can be targeted with regulation or shutdown, then the reasons for using these networks in the first place are mostly negated.
While DLCs on Lightning offer potential improvements in the areas of scalability, privacy, and limiting the amount of trust placed in price oracles, it’s unclear if the oracles in these systems are sufficiently censorship resistant to the point where the whole endeavor is worthwhile. It’s possible that introducing a third party into the equation will not be worth the potential price stability that comes with it.
For now, those who are interested in playing around with hedging via Lightning Network can take a look at LNMarkets.com, which is live on Bitcoin’s Lightning Network and does not require any KYC or AML verification. However, this derivatives platform does not currently use DLCs and is set up in a rather centralized manner.