menu
search

Blogs & Articles: Lightning Is a Liquidity Network đź”— 2 years ago

Breez Technology - Medium

Liebig’s law of the minimum is 1) wonderfully succinct; 2) applicable to a broad range of diverse contexts and; 3) not developed by Justus von Liebig, as you might think, but by Carl Sprengel. Go figure. It states:

…growth is dictated not by total resources available, but by the scarcest resource.

Startups are actually a great example of this. Whatever lack is constraining growth at the moment — talent, marketing, connections, capital (it’s usually capital), office space, lunch — immediately becomes the priority. As soon as that lack has been fulfilled or compensated, it’s time to focus on the next scarcest resource. Growth is simply a matter of eliminating one scarcity constraint after another.

The Lightning community has overcome a range of constraints together, but there will always be the next constraint to deal with. The current constraint is liquidity. As the network continues to grow, there are still too many payment failures. It’s not because of inadequate tech or lacking connections. The tech works, and the connectivity is fine.

Lightning payments are failing mainly because the network lacks liquidity, and the liquidity we have is not allocated correctly. This inhibits our growth in two ways. First, users get frustrated and slow their own adoption until Lightning becomes at least as good as fiat in completing payments. Second, we node operators lose revenue whenever a payment fails. Routing fees are our income, and allowing payments to fail is leaving money on the table, which deprives us of capital and deprives the network of reinvestment.

Liquidity is the scarce resource constraining our growth at the moment, so it would probably help to reconceptualize Lightning as a liquidity network.

Payment Network or Decentralized Liquidity Allocator?

It’s easy to say that Lightning is a liquidity network, but it’s harder to understand, so let me illustrate the concept.

First, consider a car. A car can be viewed either as a means of transportation or as an energy converter. Same thing, two characterizations. The more efficiently a car performs its essential process, which is converting energy, the better it satisfies its essential purpose, which is transporting stuff.

The same applies to Lightning: is it a payment network or a decentralized liquidity allocator? Both, of course. Allocating liquidity efficiently is its essential process, and serving as a payment network is its essential purpose. The better Lightning performs its process by allocating liquidity, the better it satisfies its purpose of enabling rapid, borderless, peer-to-peer payments.

When routing nodes optimize their local liquidity allocation, everyone benefits from a better network. Collective benefits result from the decisions of self-regarding individuals.

If this sounds familiar, it should. The idea of producing a net good for everyone by decentralizing decisions and incentives was all the rage in the 1770s and 80s. Adam Ferguson was a fan, and that other Adam made it famous as “the invisible hand”:

Every individual … neither intends to promote the public interest, nor knows how much he is promoting it … he intends only his own s̵e̵c̵u̵r̵i̵t̵y̵ prosperity; and by directing that i̵n̵d̵u̵s̵t̵r̵y̵ liquidity in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. (my amendments — RS)

I was going to include a picture of the invisible hand, which tragically failed. I could *not see* that coming. (Image: Futurilla)

Lightning is our invisible hand. Using liquidity as a signal, it lets us coordinate our activity without any other communication or consideration. Bandwidth, protocols, and platforms are epiphenomenal. Lightning is a liquidity network, and that’s what we have to get right.

Traffic Is the Source and Goal of Liquidity

So in order to achieve Lightning’s potential as a payment network (purpose), what we need to focus on is liquidity allocation (process). But “allocation” sounds like “location” — where you put something. That’s perhaps the wrong image. Liquidity allocation on Lightning is more about direction, trajectory, movement, flow.

Flow is what makes capital committed to Lightning valuable. Every time a payment traverses a routing node, the node (operator) receives a cut. Those are the fees, and they are the network’s fruit and fertilizer. Fees are the incentive to grow the network, and they are the most sustainable source of reinvestment.

Only liquid, flowing capital generates a return. Unlike a bank account, capital on Lightning is productive when it is mobile, not at rest. That’s why flow is so essential. The more capital flows, the more liquid it is, the more incremental returns it generates.

As for payment channels, they do require inbound and outbound liquidity in place to receive and forward payments, which is what generates the return. However, they should also contain no more liquidity than necessary so that no capital is idle. sats parked interminably on some lonely branch of the network are of little use to anyone.

Does the network need absolutely more liquidity or just to reallocate the existing liquidity more efficiently? Both. We need enough liquidity to handle the flow, and it needs to be in the right places for maximum efficiency. In fact, if we get the liquidity allocation just right, a positive feedback loop will emerge in which the network’s scarce resource actually becomes its driver.

The magic of positive feedback works like this: as liquidity is allocated more efficiently, the network becomes more effective (i.e. more payments go through successfully). Effectiveness is what drives the network’s utility and traffic, which results in more yield (i.e. more fees). The more yield the network generates, the more we have to reinvest, which drives more traffic and so on.

In other words, thinking of Lightning as a liquidity network turns the entire monetary system into a giant Groupon: the more we all use it, the more traffic we generate, and the bigger the discount we all receive for using it.

A Note on Routing Fees

Fees are currently rising, and it’s a good sign. Incentives (fee revenue) and utility (successful payments) grow together, which is also good news. Fees are yield, and yield means the network is growing sustainably.

The idea that Lightning would always and automatically have lower fees than on-chain transactions is a misconception. Lightning is faster and payments are settled instantly. When deciding which medium to use for which transaction, fees are only one consideration among several. (To take an analogy from fiat, checking accounts, savings accounts, credit cards, and PayPal all coexist because they all have their uses.)

The key to lowering fees is, you guessed it, perfecting liquidity allocation. The more liquidity is committed and the better it is allocated, the lower the marginal return on any forwarding event can be while still generating a profit. In other words, the more a given unit of capital crosses a node and generates a return, the lower fees can be set while remaining efficient and profitable. In still other words, by improving liquidity allocation, we can give the whole network a volume discount and still make money!

Optimizing Liquidity

Assuming the reconceptualization of Lightning as a liquidity network makes sense so far, one of life’s great questions remains: what now? Even if we agree that liquidity is now Lightning’s key parameter, what should we do about it?

In order to be a better payment network, Lightning needs to do better at allocating liquidity. All that’s required is for every node to take liquidity seriously and optimize their local operation. If all routing nodes optimize for throughput individually, the network will grow and we’ll all benefit collectively. Thanks invisible hand!

Many Lightning developers see their task as developing the network’s connectivity. The network’s physical connectivity, however, is relatively trivial. The relevant bandwidth on Lightning is in fact determined by channel capacity, which is a question of how much liquidity is committed where. We don’t build this network by laying cables and defining ports, but by committing and re(al)locating capital. That is the key optimization problem that will separate garage hobbyists from growth businesses.

Liquidity allocation is one area where good tools are still lacking, but some promising candidates are in development. For example, splicing effectively makes channel capacity variable, not fixed, which helps LSPs to reallocate liquidity while maintaining their user experience. PeerSwap is just as cool. The idea here is to obviate opening extra channels and multi-hop rebalancing, the latter of which often knocks other nodes’ channels off balance and compromises natural payment flows. Instead, PeerSwap offers a way to increase inbound liquidity by simply executing an atomic on-chain swap.

Perfectly balanced. As all things should be. (Image: imgflip.com)

With liquidity tools, like Lightning Pool or Liquidity Ads, and rebalancing tech, like PeerSwap and splicing, we have a basic toolset to start allocating liquidity rationally and professionally, like our livelihoods depended on it. And by allocating liquidity properly, helping the network to gain utility and grow, our livelihoods and those of many other incoming LSPs will depend on it because it will be a fulfilling, lucrative business.

We know what to do and how to overcome our biggest current scarcity constraint. Now we simply need to act.

Liquidity Allocation Is the Future of Our Network

For many of us who spend much of our time on Lightning’s backend and technical specs, seeing it as a liquidity network is a bit of a rethink. Perhaps we need to think less like network admins and more like fund managers. Remember: liquidity is the goal, and it’s a function of traffic and yield. The market sets yield. It’s out of our (invisible) hands. We can, however, work on traffic and liquidity.

If your node is routing a lot of payments and generating fees, you’re doing it right. If not, keep tweaking until it does. That’s the algorithm to success.

Lightning Is a Liquidity Network was originally published in Breez Technology on Medium, where people are continuing the conversation by highlighting and responding to this story.

Feel free to send a tip using tippin.me

Or alternatively you can send a few sats directly:

btc logo BTC ln logo BTC (Lightning)

btc tip qr

33ELQ1ye29gB6YVQY6zRLFVCNYkJez9jMh

lightning tip qr

lnurl1dp68gurn8ghj7cm0d9hxxmmjdejhytnfduhkcmn4wfkz7urp0yhn2vryv5ukvdm995ckydph956rvv3h94sk2dny95mkgv34xdsnvvrpv4jxz6whyrn