Bueno, esto escaló rápidamente.

En mayo, hablé con el omnipresente podcaster de Bitcoin, Peter McCormack, quien estaba en El Salvador siendo testigo de primera mano, no solo de la adopción de bitcoin como moneda transaccional dentro de las comunidades salvadoreñas, sino también de una proliferación significativa de Lightning Network, una aplicación que liquida instantáneamente las transacciones de bitcoin entre usuarios.

Solo unas semanas después, los rumores desde la conferencia Bitcoin 2021 en Miami arreciaron. Se decía que un país iba a “adoptar” bitcoin como moneda de curso legal. Inmediatamente me vino a la mente El Salvador, debido a esa conversación con McCormack en mayo, pero nunca pude haber imaginado el curso de los eventos que se han desarrollado esta semana.

En la conferencia, el prodigio de Lightning Network, Jack Mallers, subió al escenario y lanzó un mensaje emotivo, acompañado con un anuncio que sacudió el panorama de la moneda digital durante los días siguientes. Todos los que asistieron, pudieron ver cuánto significaba para él este anuncio en particular. Mallers compartió su pasión por Lightning Network y describió sus esfuerzos en la pequeña nación centroamericana y luego, sorprendentemente, presentó un mensaje del presidente de El Salvador, Nayib Bukele, quien anunció sus planes de enviar un proyecto de ley a la Asamblea salvadoreña, para convertir a Bitcoin en moneda de curso legal en su país.

Como era de esperar, la noticia provocó un gran revuelo, y las piezas de dominó realmente comenzaron a caer. Funcionarios públicos electos en Paraguay, Panamá, Argentina, Brasil, Colombia, México y Ecuador comenzaron a unirse al movimiento para clasificar Bitcoin como moneda de curso legal en sus países, y la avalancha de tweets pro-bitcoin en español fue coronada con una sesión de la Asamblea de El Salvador, realizada hasta altas horas de la noche, y que finalizó con la aprobación oficial de una ley que declara Bitcoin moneda de curso legal en el país.

Si bien los diputados aún están deliberando sobre los detalles exactos de la legislación y aún cuando existe un importante escepticismo sobre la verdadera intención de cualquiera de estos políticos latinoamericanos (un escepticismo saludable ante todas las promesas políticas es una postura sabia por defecto), lo que más importa son los ecos que se pueden derivar de la aprobación de la legislación salvadoreña.

Estos son algunos de mis pensamientos y conclusiones:

1. La idea de que “los gobiernos prohibirán el bitcoin” está oficialmente enterrada y ahora roza el absurdo. Claro, algunos dictadores encontrarán una razón para criminalizar la propiedad y el uso de Bitcoin para proteger sus regímenes tiránicos, pero ahora tenemos al menos un país que considera bitcoin como moneda de curso legal. Los tibios, seguramente nos recordarán cuán pequeña es la nación de El Salvador, o cómo los funcionarios del gobierno allí pueden ser corruptos o dictatoriales. Pero debemos seguir mirando el panorama general: Bitcoin es empoderamiento financiero y ahora algunas naciones están comenzando a reconocerlo así. Siempre que suficientes naciones, no solo clasifiquen bitcoin como legal, sino que realmente lo adopten, el arbitraje regulatorio llevará a los propietarios y negocios de Bitcoin a naciones que sean amistosas con él.

2. La idea de que “bitcoin no es una moneda debido a la volatilidad” también está muerta, afortunadamente. Quienes están en occidente deben revisar sus privilegios a nivel financiero, y darse cuenta de que, aunque ellos confían en el dólar o el euro, muchas personas alrededor del mundo no pueden darse ese lujo. Una nación ha elegido Bitcoin como un sistema paralelo para operar sus finanzas, y los políticos latinoamericanos apenas están comenzando a caer en cuenta de esta decisión. El impulso es palpable, y el genio está definitivamente fuera de la lámpara: los centroamericanos y sudamericanos quieren la opción de denominar su vida y trabajo en bitcoin. Además, es importante señalar cómo el proyecto de ley que se aprobó en la Asamblea salvadoreña fue un proyecto de ley centrado en Bitcoin. El documento convierte a Bitcoin en moneda de curso legal: no cualquier otra criptomoneda, ni stablecoin respaldada en dólares estadounidenses, ni moneda digital del banco central (CBDC), ni tampoco una moneda digital supranacional (derechos especiales de giro del FMI, por ejemplo), incluso a pesar de la volatilidad. Bitcoin es una moneda porque la gente está dispuesta a usarla y comerciar con ella y, por eso, naciones como El Salvador ahora están dispuestas a clasificarla como moneda de curso legal.

Bitcoin dejó de ser riesgoso para una nación debido a la volatilidad de sus precios en términos de dólares; más bien, las monedas que no son bitcoin, como el dólar estadounidense, son riesgosas para una nación sin su propia moneda (como El Salvador) ya que depende de políticas ajenas, especialmente dado el despilfarro fiscal y monetario de los Estados Unidos. Estén o no de acuerdo con las políticas económicas de Estados Unidos, los salvadoreños no tienen nada que decir al respecto. Con Bitcoin, la política está grabada en piedra a través de un algoritmo, nivelando el campo de juego monetario para las naciones poderosas y las geopolíticamente menos representativas.

3. Bitcoin es geopolítica. El proyecto de ley salvadoreño y las subsiguientes naciones latinoamericanas que se suban a bordo del tren Bitcoin por este impulso plantean un aspecto crucial de la actual revolución monetaria Bitcoin. Muchas naciones de América Latina tienen una intensa relación de amor-odio con el dólar estadounidense. El Salvador, Ecuador y Panamá están completamente dolarizados y, por lo tanto, tienen economías y tasas de inflación que están sujetas a las políticas impuestas al norte de sus fronteras. Sin embargo, dependen en gran medida del consumidor estadounidense y de las relaciones comerciales estadounidenses para tener una economía saludable. La nueva legislación salvadoreña nos recuerda que las naciones latinoamericanas no permanecerán a la sombra de Estados Unidos para siempre. Los ataques centenarios de los conglomerados frutícolas estadounidenses, los golpes militares patrocinados por occidente y la irrupción del FMI en la región a través de préstamos, han dado forma a una desconfianza latinoamericana hacia el sistema monetario centrado en el dólar. Ahora sus líderes y ciudadanos se están dando cuenta de que, por primera vez en la historia moderna, hay una salida.

Y seamos francos, la adopción de Bitcoin en todo el mundo no es mala para los Estados Unidos ni tampoco para el dólar estadounidense como moneda internacional: el público estadounidense y las empresas estadounidenses se beneficiarán de una revolución de Bitcoin porque una considerable cantidad de la riqueza derivada de bitcoin ya está situada en los Estados Unidos. No obstante, ahora Estados Unidos debe fijar posición y dar forma a su propia política pública en torno a Bitcoin. Porque si no lo hace, los bitcoiners y las empresas de Bitcoin abandonarán sus fronteras, probablemente hacia el sur.

Gracias a Javier Bastardo por traducir el trabajo original del inglés al español. Por favor, echen un vistazo a mi libro Layered Money, el cual espero tener traducido al español pronto.

At last, my worlds have collided. No, not in the way they collided for social miscreant George Costanza, but rather in a beautiful and harmonious way. Software company MicroStrategy will soon issue a $400 million bond in order to purchase Bitcoin only weeks after it converted $250 million of its treasury reserves from dollars to Bitcoin. And with that, the bond markets and the Bitcoin market will merge, and the two parallel careers I’ve built for myself will suddenly become one.

Bonds and Bitcoin

I spent my youth aspiring to participate in the financial markets, learning how to analyze charts and observe linear trends before my teenage years. Eventually I realized my dream and became a US Treasuries trader for an institutional asset manager in 2016. I safely guided enormous client portfolios in and out of positions in the dollar’s “risk-free” asset on behalf of my former employer, trading over $100 billion notionally per year. Much of that volume occurred in Treasuries, which were treated as “cash” on the balance sheet of each institutional client. These Treasuries (T-Bills and T-notes with less than 2 years until maturity) lacked any quantifiable risk to us and our clients because Treasuries are still the safest way to store dollars in a broken dollar system. The volume I traded was personally staggering but existed simply because corporations, universities, and governments have so much cash they literally have nowhere else to put it. I didn’t mind: the volume I traded with the world’s largest investment banks gave me access to some of Wall Street’s finest minds. But the sheer volume of money sloshing around the financial system steered me toward an even more important path: it pointed me down the Bitcoin rabbit hole, a world previously unfamiliar to me that possessed a much stronger gravitational pull on my intellectual curiosity than any other macroeconomic market I had experienced prior. Little did I know, bonds and Bitcoin would be entirely joined at the hip only half a decade later.

Corporate New Issuance

One of the most interesting things I saw during my time on the fixed-income trading desk was massive corporate bond issuance to the tune of trillions of dollars annually. But what do those corporations do with all that cash once they issue bonds? Until they’re ready to spend it on projects, research and development, or share buybacks, a lot of the money ends up in Treasuries and other interest rate markets. I had a front seat to the flurry of fixed-income market activity revolving around corporate new issuance. Corporations and banks constantly place hedges via interest rate swap, foreign exchange swap, and Treasury futures markets in order to quantitatively manage their newfound balance sheet expansion. This finally brings us to MicroStrategy, which won’t need to hedge its interest rate position upon its new issue but instead will need to purchase an enormous slug of Bitcoin.

Anticipating Fireworks

When MicroStrategy successfully prints its debt issue and takes custody of $400 million later this month, it will bolster its cash position which it proudly denominates in bitcoin (BTC) rather than in dollars (USD). What ensues might be the most fascinating market activity in Bitcoin’s young history. While traditional economic and financial theory suggests that the news of an incoming $400 million purchase of Bitcoin in the open market has already been priced into the market, reality might tell an entirely different tale. Never before in Bitcoin’s history has such a gargantuan purchase been pre-announced, and never before has such a wave of buying hit the market all at once. Even the staunchest “efficient-market-hypothesis” adherents will eagerly observe the subsequent price action to see just how a purchase of 20,000 BTC is met by the readily available (or not so available) supply across Bitcoin exchanges. Acquiring it will certainly put pressure on the price, regardless of one’s opinion on the speed at which markets adjust to news.

Even more interesting than the BTCUSD price impact of MicroStrategy’s bond issuance is the linkage between the bond and Bitcoin markets that will undoubtedly blossom as a result. Just as corporate new issue and interest rate swap markets are linked (a process called rate-lock explained here), corporate new issue and Bitcoin markets will now be linked going forward. Investment banking trading desks will be forced to offer clients financial products that allow Bitcoin hedging and conversion for clients looking to replicate MicroStrategy’s effort. By converting a balance sheet liability (its bond offering) into Bitcoin as an asset, the company is betting that its cost of borrowing will pale in comparison to the time value of money associated with holding Bitcoin. And the world will be watching to see the result.

Layered Money

MicroStrategy’s poetic and wildly enthusiastic-about-Bitcoin CEO Michael Saylor deemed the dollar an inferior cash instrument to Bitcoin in a flurry of tweets and media appearances over the past few months to justify the allocation. He might be the first CEO of a large corporation to engage in this type of treasury reserve allocation, but he definitely won’t be the last. In my forthcoming book Layered Money: From Gold and Dollars to Bitcoin and Central Bank Digital Currencies, I examine how Bitcoin has already achieved legitimacy as a global reserve currency and will continue to drive corporations like MicroStrategy into a state of balance sheet denomination duality in which entities hold cash denominated in both USD and BTC. MicroStrategy’s share price, denominated in USD, has partially morphed into an expression of the BTC/USD price as a function of this duality because so much of its assets are held in Bitcoin. This enigma will leave executives and policy makers scratching their heads in the years to come as they try to decide how to denominate their reserves, especially if the Bitcoin price reverts to its parabolic roots.

I spent this year weaving both of my worlds into one because the blurred line between Bitcoin and macroeconomics frankly disappeared in 2020. I did this by writing a book about the international monetary system that includes a vision of the future with Bitcoin at the center. Bitcoin won’t replace all currency on this planet, but it will serve as the reserve asset of all digital currencies just as it serves as the reserve currency in the cryptocurrency world today. Central banks are about to launch their own crypto-competitors, and banks will certainly follow suit in order to stay relevant in the rapidly changing monetary environment. But all new digital currencies, from central banks and banks alike, will eventually face final settlement versus BTC as the only digital currency on our planet immune to supply manipulation. I am beyond excited to share my vision for our monetary future in only a few weeks: Layered Money will be available on Amazon worldwide on January 26, 2021. The Kindle version can be pre-ordered here, and print and audio versions will be available on the release date. Please visit my website LayeredMoney.com for more information and follow me on Twitter.

1. The Bitcoin Second Layer

Bitcoin’s antifragile protocol and its exponentially increasing network effects make it a behemoth, gradually swallowing up global economic activity. The latest of these network effects is a second layer protocol called Lightning Network, which uses bitcoin’s base layer protocol as its security. The concept of layered money is not new in monetary history. In this writing, I’ll be using gold as an analogy to describe why bitcoin will evolve in layers on its way to world reserve currency status.

Layered Money

Gold has served as money for millennia due to its unique chemical properties and its global network effects. But gold has not acted as money only in its raw physical form, or on its first layer. Gold is a perfect example of how a layered money system evolves. Let’s take a look at gold as money in a four layered example. I’ll describe the rule set, or protocol, of each gold layer so the reader can imagine similarities to bitcoin’s layered protocol approach.

The first layer of gold is the physical gold in its raw form after it is mined: gold nuggets. The protocol of gold’s base layer has only one rule. The element must adhere to the properties of the periodic table’s 79th element. If it does, it is gold; if it does not, it is not gold. Consensus around this “79th element” protocol is millennia old.

The second layer of gold is raw gold that has been melted and shaped into bars and coins following a standardized protocol of purity, weights, and measures. Mints can be controlled by governments or by private enterprise, but the coinage will only be considered money by users if the “79th element” first layer protocol is followed.

The third layer of gold is gold certificates. These are claims issued by banks that have taken gold on deposit. Third layer banks will only use gold coins and bars that follow the consensus second layer protocol of purity, weights, and measures and only from mints that are properly following the “79th element” protocol. These certificates can act as money but carry counterparty risk of the issuer.

The fourth layer of gold is certificates backed by bank-issued gold certificates. A liquidity provider can issue these certificates, which would require several layers of trust by the user. Somebody accepting fourth layer gold as money has to trust that the liquidity provider has real gold certificates, which are backed by physical gold at a bank that follows a standardized purity for gold deposits.

Each layer uses the layer beneath it for consensus and security. Money will always see a multiple layered expansion as it evolves, and each layer has costs and benefits. You can mine your own gold, but this process is very expensive with a high barrier to entry. You can buy gold coins and bars easily in most parts of the world, but using them for day to day commerce is unfeasible. As a merchant, you can accept gold coins but either have to trust the purity or assay the gold yourself. Once you’re using the paper certificate layers, you now are engaged in counterparty risk, but have easier capacity for transactions. Each layer serves a different function. Base layers are for final settlement, while higher layers are for facilitation of economic activity.

Bitcoin’s First Layer

Bitcoin’s first layer, or base layer, is a protocol proposed in 2008 that has reached a global state of consensus. Bitcoin’s unit of account, also called bitcoin, has exchange rates with currencies around the world in markets that are growing in depth and liquidity. The protocol itself has added vital updates in its young life that have strengthened both security and usability. The network’s uptime and its ability to prevent double spends are relentless.

Critics of bitcoin often incorrectly identify a feature of bitcoin, its slow speed, as a flaw. Bitcoin’s confirmation process is meant to be slow because of security reasons. The intent of bitcoin is censorship-resistant, scarce digital cash, not a speedy payments solution. The best way to think about bitcoin’s base layer protocol is as a final settlements layer. The final settlement of physical gold is also a slow, clunky, and expensive process. Imagine, for example, companies in different parts of the world settling large balances of gold by loading ships with physical gold bars and sailing fortunes hundreds of miles across seas. Not only is the delivery an arduous process, but the verification process is also quite a task. In theory, every single piece of metal would have to be tested for purity. This process should be considered as historical context for what is required to have true final settlement of scarce money. The energy consumption required to find valid blocks has dramatically increased over time which increases security, but difficulty adjustments ensure bitcoin still averages six blocks per hour.

Centralization and attack vulnerability, while both permanent concerns to owners of bitcoin, have not prevented huge sums of capital to be stored in bitcoin’s denomination. The denomination, commonly known as BTC, despite its commonly quoted exchange rates with fiat currencies, stands alone as a final settlement asset. With a secure and reliable final settlement layer firmly in place, development of higher layers can ensue: enter the Lightning Network.

Bitcoin’s Second Layer

Lightning Network is a second layer protocol on top of bitcoin. The protocol uses bitcoin as its native denomination, meaning that Lightning can only be used by those with real bitcoin. Under the hood, Lightning Network is a web of bidirectional payment channels, but the protocol’s functionality is beyond the scope of this writing. The important takeaway is that Lightning allows for the instantaneous transfer of bitcoin from peer to peer with one considerable difference from the first layer: channel balances can adjust but do not require immediate settlement on the base layer. Simply stated, Lightning transactions are unsettled bitcoin transactions.

Having unsettled bitcoin comes with risk, however. Bitcoin held in Lightning Network payment channels can be stolen by malicious actors if node operators are not properly monitoring the channels and the base layer. Malicious actors have a strong disincentive to steal, however, as fraudulent activity gives the victim ability to sweep all funds from the channel. Now that we have covered some of Lightning Network’s basics, let’s take a look at the importance and the significance of this new layer on top of bitcoin.

The Importance of Lightning

Firstly, the Lightning Network is a zero sum, fully reserved routing network.You may only use Lightning if you bring in real bitcoin, and all routing fees earned by liquidity providers are paid for by liquidity consumers. This allows Lightning Network to operate with one of the primary features of bitcoin, its limited supply.

Secondly, Lightning does not carry the burden of base layer confirmation. This allows for bitcoin to be exchanged ad infinitum without consuming precious block space. Lightning nodes can decide to take final settlement of their bitcoin by broadcasting the correct state of a payment channel to the base layer at any time, but they don’t have to.

Lastly, Lightning transactions can be interpreted as financial agreements, making Lightning Network a capital market layer. The network’s structure is built as a market for capital and liquidity. Bitcoin can now instantaneously fly around the world without having to wait an hour for final settlement. The two core components to any financial transaction, time value and risk premium, can be derived from Lightning transactions. Opportunity cost tradeoffs can be calculated, and bitcoin can be leased on a short term basis to the network without surrendering one’s private keys. With gold, there is no way to accrue positive interest on capital without surrendering the physical metal. This makes Lightning Network an absolute game changer for the entire concept of capital markets: income without explicit counterparty default risk.

Digital Gold

Bitcoin is often referred to as digital gold, but I’ll propose a more specific analogy. Bitcoin’s base layer is like digital physical gold, while Lightning Network is like digital paper gold but without the counterparty risk. The second layer is unsettled and less secure, but infinitely more usable. Bitcoin is incredible at censorship resistance and decentralization, but frankly terrible at speed and efficiency. Critics of bitcoin completely miss the fact that speed and efficiency should take place on higher layers, NOT on the base layer. Lightning’s arrival will show the world bitcoin’s true capabilities. If gold could only be used as a physical metal, global economic activity would have been prohibitive on a gold standard. Thankfully, paper gold satisfied the liquidity and capital market layer. Lightning Network ensures bitcoin’s path to global reserve currency because it makes bitcoin come alive. Once bitcoin can be transacted around the world without the constraint of a slow confirmation process, it can graduate from reserve asset to reserve currency. Lightning Network finally frees bitcoin from its base layer shackles.

2. The Time Value of Bitcoin

The HTLCs in Lightning Network give bitcoin a path to become a global reserve currency. Lightning Network provides a framework to measure the time-value of bitcoin, a precursor for a capital market and reserve currency status. Observable variables in Hashed Time Locked Contracts can be used to calculate the interest rate received on bitcoin held in payment channels, allowing investors to measure their opportunity cost of capital. Lightning Network wallet software should include ways to calculate interest and prove the rate received in a trust-minimized way. A reference rate should be developed, using consensus to dictate how the rate is calculated. This reference rate can anchor off-chain bitcoin lending into the global economy, leading to bitcoin-denominated banks, credit ratings, debt capital markets, and eventually an entire financial system: a path toward status as a global reserve currency.

Calculation Method

Three observable variables are needed to calculate an interest rate: principal, cash flows, and time. In Lightning Network, the principal is the amount of bitcoin in a payment channel; cash flows are routing fees; time is the block-time in which the fee collection is measured. Wallet implementations should experiment with different interest rate calculation methods with the eventual goal of a consensus method. The US Dollar has Treasuries, Fed Funds, LIBOR, OIS, and SOFR all acting as reference rates within the capital market for lending, borrowing, and swapping cash flows. Bitcoin needs to establish a reference rate of its own, referred to in this writing as LNRR (Lightning Network Reference Rate).

There are many possible ways to calculate LNRR. Principal may be measured once per block or using an average over time. Fees may be measured for individual HTLCs, individual payment channels, or Lightning Network nodes with multiple channels. Block-time may be measured by the locktime of HLTCs or measured one block at a time. Compounding conventions may be discrete or continuous. On-chain fees paid to open and close channels may be included or excluded in the calculation. We need to experiment with calculation methods because bitcoin is an entirely new asset class and shouldn’t adhere to financial conventions of the past, even though traditional fixed income markets set the bar extremely high for financial sophistication.

Time-value of bitcoin

Fees, time-value, and security risk premiums are discussed in the The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments by Joseph Poon and Thaddeus Dryja:

The time-value of fees pays for consuming time (e.g. 3 days) and is conceptually equivalent to a gold lease rate without custodial risk; it is the time-value for using up the access to money for a very short duration.

Historically, one of the largest component of fees and interest in the financial system are from various forms of counterparty risk — in Bitcoin it is possible that the largest component in fees will be derived from security risk premiums.

Fees in Lightning Network can be attributed to two components, time-value and security risk premium. Fees compensate the leasing of bitcoin which translates into time-value. Positive interest rates should attract capital and competition. But Lightning Network node operators investing capital are not doing so purely risk-free. They are taking on a variety of risks, most notably the risk of using hot wallets to stake liquidity to the network. Therefore, interest rates will vary between nodes due to different security practices, captured here by the catch-all variable security risk premium.

r = time-value + security risk premium

Lightning Banks

Lightning Network will birth Lightning banks. Their first function will be to provide liquidity to Lightning Network by funding payment channels. They will try to position themselves as central routing hubs, capturing as many fees as possible. Competition will be open and fierce. Those with the greatest ability to efficiently manage payment channels and actively optimize routing positioning will profit.

Reference Rate

LIBOR was originally intended as an inter-dealer interest rate, however market conditions and manipulation scandals have significantly changed its role. Despite its evolution, LIBOR’s model could serve as an example for LNRR to follow. The calculation method for LIBOR is essentially a panel: banks are asked to submit rates and these rates are aggregated to form a reference rate published once a day. Lightning banks can publish their interest rates to each other in order to foster a dealer community similar to the LIBOR panel banks. Any node that can publish an interest rate can potentially contribute to LNRR.

Once Lightning banks establish LNRR, they can reference this rate and charge a spread for loans that are not secured by the Bitcoin blockchain. They can use the reference rate to attract deposits which would also not be secured by the blockchain. While off-chain, trusted, bitcoin denominated capital market activity does not benefit from Bitcoin’s immutability, it is essential for the establishment of bitcoin as a currency capable of global economic activity. Economic activity requires a tradeoff between time preferences which can only be achieved when savers are allowed to lend capital.

Reserve Asset to Reserve Currency

LNRR is not some magic solution. This paper is a suggestion to the Lightning developer community to start experimenting with the translation of HTLCs to a financial framework. We cannot go from Trace Mayer’s sixth network effect of financialization to the seventh network effect of reserve currency status without the correct financial tools. Bitcoin has already emerged as a new asset class and is now acting as a reserve asset for millions around the world. Transitioning from reserve asset to reserve currency will present a challenging path. Ideas like LNRR should be discussed and explored so that we can continue to push bitcoin forward as the world’s best abstraction of money.

3. The Bitcoin Risk Spectrum

Bitcoin is already a reserve asset. It is the world’s first true example of decentralized digital scarcity, and its elegant, predetermined supply schedule reinvents monetary policy. Its value is recognized by millions of people who own bitcoin as a savings vehicle, speculative investment, or currency hedge. Bitcoin is a reserve asset because millions of people own it as one. Its next step is to transition from a reserve asset to a functioning reserve currency by unlocking the bitcoin capital market. Lightning Network’s arrival finally allows us to assign time value to bitcoin, and we can begin building bitcoin’s capital market from first principles.

Lightning Network’s HTLCs

HTLCs are financial agreements with two important properties that eliminate reliance on trusted third parties. Firstly, the contracts have an embedded call option on the counterparty’s bitcoin which dissuades theft. Secondly, the contracts have an expiration, which prevents balances to be held in limbo to perpetuity. These two properties remove counterparty risk but instead introduce payment channel management risk. Routing Lightning payments is the equivalent of a short-term bitcoin lease and allows the router to earn fees; these fees can be used to calculate interest earned on bitcoin staked to Lightning payment channels.

Traditional Capital Markets

Traditional capital markets have a risk spectrum: generally speaking, higher variance of returns is positively correlated with a higher expected return. More risk, more reward. It is important to note that risk-free rates are entirely conceptual and theoretical. They are simply a matter of convention to facilitate financial theoretical research and improve communication. Therefore, this article is an attempt to discuss and derive bitcoin-native financial theory, including how bitcoin can be reconciled against other assets. Bitcoin is still trillions of dollars of market capitalization away from becoming a legitimate alternative to other deep capital markets like the ones denominated in US Dollars, Euros, Yen, Pounds, and Yuan. Before we dissect bitcoin’s risk spectrum, let’s take a look at that of the US Dollar to get a sense of which aspects bitcoin should copy and which it should reinvent.

US Dollar Risk Spectrum

Why is the US Dollar the world’s reserve currency? There are many reasons including geopolitical and economic prowess, but one of the reasons is the depth of its capital market. There are over $100 trillion in bond and equity securities, allowing owners of US Dollars to easily find a home for them. Its capital market can be viewed as a risk spectrum, with risk on the x-axis and expected return on the y-axis.

The first point (illustrated) on the risk spectrum is US Treasury debt. Financial theory requires a risk-free asset to establish baseline interest rates, and currently that asset is US Treasuries. The obvious flaw of this financial theory is that US Treasuries are not truly risk-free. They have default risk, albeit appropriately characterized by market as the lowest possible default risk that an investor can attain. (Many sovereign bonds now have yields lower than yields in the United States, but those bonds are not denominated in US Dollars. This article is written only comparing bitcoin to the US Dollar).

The second point is corporate bonds. Companies issue fixed obligations at a spread to US Treasuries; for example, this year Walmart issued a 5yr bond at 5yr Treasuries plus 0.60% and General Motors issued a 5yr bond at 5yr Treasuries plus 1.37%. Each of these companies used the 5yr US Treasury as a reference rate. Investors consider the risk premium, or creditworthiness, of each company relative to Treasuries. We can see from this example that bond investors view Walmart as more creditworthy than General Motors because Walmart borrows at a lower spread to Treasuries. This is why reference rates are considered an anchor for debt capital markets, because they more easily allow for relative value comparisons.

Further along the risk spectrum are investments with higher risk profiles, such as publicly traded equities and venture capital funds. Theoretical formulas for the expected return on equities usually include a combination of the risk-free rate and the company’s risk premium. Venture capital investors will seek an even higher return because the probability of principal loss is perceived to be higher than that of public equities. Theoretical risk premiums are added to each subsequent point of the risk spectrum, all anchored from the risk-free rate.

Bitcoin Risk Spectrum

Bitcoin’s capital market should be designed from first principles because its final settlement does not require trusted third parties. Final settlement of the US Dollar has counterparty risk because deposits are considered a liability on banks’ balance sheets. Holders of US Dollars would rather face the US government as a counterparty rather than banks, so they prefer to purchase US Treasuries with their deposits. Either way, the final settlement has counterparty risk. Additionally, the US Dollar itself depends on a single nation and has a single entity controlling monetary policy in a discretionary way; bitcoin avoids both of these risks. Let’s take a look at Bitcoin’s risk spectrum.

The first point (illustrated) on Bitcoin’s risk spectrum is bitcoin held in cold storage. The analogy commonly used for cold storage is a gold bar held in your hand. There is no counterparty risk; the risk is its storage and security, much like if you had possession of physical gold. Skilled storage and security practices make loss less likely, and the advent of robust multisignature solutions further reduces risk. Private key management anchors the bitcoin capital market much like the timeliness and consistency of the US government paying back its debt obligations anchor the US Dollar’s capital market. The expected return on cold storage bitcoin is at best zero and is actually negative if you consider that storage costs and on-chain transaction costs are non-zero.

I am proposing that the second point on Bitcoin’s risk spectrum should be LNRR, the Lightning Network Reference Rate. Routing fees earned on bitcoin staked to Lightning payment channels can be expressed as an interest rate. The rates received on the payment channel or node level can be hashed and cryptographically provable. Node operators can opt-in to publish realized interest rates on their capital. If a consensus can be reached on an interest rate calculation protocol, capital providers can publish interest rates in an open and transparent way. Positive interest rates will attract bank-like entities that believe they can earn positive return using effective payment channel management and security techniques. Some bitcoin previously held in cold storage will seek the income attainable in Lightning Network, the first ever example of an opportunity cost tradeoff in bitcoin that doesn’t require additional counterparty risk. Bitcoin staked to Lightning is the most unique income producing asset in all of monetary history: income with zero counterparty risk. The historical implications of this on capital markets are tremendous.

A huge leap in risk exists between the second and third point on Bitcoin’s risk spectrum. The first two points, as we have established, have various security and management risks but no counterparty risk whatsoever. Real world lending of bitcoin has genuine counterparty risk, whether using exchange-based lending platforms or other forms of direct lending. In theory, these rates of borrowing should be higher than LNRR, and capital providers could use LNRR to make relative value decisions between bitcoin leasing via Lighting and off-chain bitcoin lending. Any real world lending will not have bitcoin’s blockchain as security. Lenders will need strong contracts in jurisdictions with strong rule of law to ensure repayment of capital, just as they do with fiat currencies. Complete loss of principal remains.

4. The Lightning Network Reference Rate

I present a three part proposal for Lightning Network node operators. The first and most crucial part of the proposal is a node-level calculation standard for the accrual of satoshis. The Node Accrual Rate (NAR) is offered as a formula to calculate the profitability of an individual Lightning node, expressed as an annualized interest rate.

The second part of the proposal is to convince Lightning node operators to disclose their NARs to each other. Transparency and financial disclosure are core tenants of capital markets, and the disclosure of NARs could correspondingly push bitcoin forward on its path to becoming a more robust asset class.

The third and final part of the proposal is to advocate a framework in which NARs across the network can be aggregated, averaged, and reported as one rate called the Lightning Network Reference Rate (LNRR). LNRR can pave the way for a world of relative value calculations and be instrumental in the pricing of off-chain bitcoin lending.

This is not a proposal for any changes to Lightning Network itself, nor a call for all nodes to share fee accrual data. Nodes will elect for themselves whether or not to share data, and most will likely choose not to do so. The formula is merely a suggestion for developers trying to capture the economics of payment routing.

The Time Value Layer

The Lightning Network sets up a framework from which we can calculate the time value of bitcoin. Interest rate calculations must have three known inputs: principal, income, and time. In Lightning terms, a node opens channels with other nodes and broadcasts the channel opening, essentially locking up principal for a predetermined amount of time. Assuming incoming channels are also opened to the node, the node is now positioned to route payments and charge fees for doing so. These routing fees can be considered income. The ending calculation can be expressed in many ways, but through time node participants will elect standards around which to coalesce. This proposal is a starting place for the discussion around these standards. If multiple standards emerge, I would view this as a positive development because competing calculation standards would foster deeper study of Lightning Network routing economics.

Lightning Network is also an optionality layer. Optionality is relevant to Lightning because it serves to offset one of the primary risks undertaken by Lightning node operators: malicious counterparty risk. Nodes carry the risk of their channel counterparts broadcasting a previous channel state, but this risk is theoretically negated by embedded call options which become executable upon malicious activity. The settlement optionality simultaneously serves as a security enforcement mechanism and a velocity accelerant.

Proposal #1: Node Accrual Rate

I propose the idea of a Node Accrual Rate (NAR) for individual Lightning nodes that desire a standardized method for calculating their realized interest rates. Nodes should be able to automatically calculate their rate of return on capital allocated to facilitate Lightning Network payment routing. Rates can be calculated by querying observable data available in their lnd, c-lightning, or Eclair clients. The following is a proposal for one way to calculate the rate using a generic formula for compounding interest and adapting for block time. The node data can be sliced and diced dozens of logical ways, and I look forward to many counterproposals that are sure to include innovative ways to capture return data.

NAR = [(p+f)/p]^(52,560/n)-1

Let n = the measurement period, expressed in number of blocks, suggested minimum value of 100

Let p = node’s average balance held in channels over the measurement period, expressed in satoshis

Let f = total routing fees earned by the node over the measurement period, expressed in satoshis

52,560 is the approximate number of blocks per year to normalize NAR as an annualized rate

n:

The suggested 100 block minimum measurement period is arbitrary but matches the minimum block time before mining rewards become spendable. Said another way, your Lightning node should be active a certain number of blocks in order to reasonably measure an annualized rate of return. I believe this minimum can be increased to cover at least one full difficulty adjustment period of 2,016 blocks once routing activity becomes more commonplace. A longer minimum measurement period would make for higher quality and less noisy data.

p:

The average balance of a node throughout time can be measured a multitude of ways. Striking channel balances upon each new block confirmation and then averaging these amounts over the measurement period could be a clean and impartial way to determine p.

f:

Lightning Network node operators are already sharing f with each other. I’ve seen numerous “day_fee_sum” screenshots on Twitter with positive integers next to them. Accelerated adoption of the Lightning Network over the past few months brought time value to bitcoin in a trustless way, and nodes are earning sats as a result. Node operators already sharing f with each other will soon be calculating and sharing their NARs as well.

Proposal #2: Disclosure of NARs

Lightning node operators currently volunteer information about collecting routing fees, managing payment channels, and other emergent routing techniques. In a similar way, I anticipate and strongly encourage nodes to volunteer their NARs. Sharing NAR data is an easy way to display profitability to other capital market participants. The exchange of profitability information is a foundational tenant of capital markets; the widespread exchange of NAR data between nodes would accordingly bring long term health to bitcoin’s capital market. Node operators are already disclosing the small amount of sats they’ve earned by routing payments through the Lightning Network, leading me to believe that such NAR exchanges will be commonplace for nodes motivated by profit or by transparency. Some nodes will look to attract capital in order to leverage their newfound skill set, even though most nodes will not be motivated to share data. Some nodes will be dishonest about their NAR, and the market will have to identify fraudulent disclosures just as forensic accountants dissect every disclosure from publicly traded corporations.

Advertising profitability, even if unaudited, will attract capital looking for return. Example: a Lightning node with sufficient capital and well positioned inbound and outbound payment channels earns a NAR (annualized return) of 0.25%. Funded with 10 million sats (0.1 bitcoin/~$400), the node earns about 957 sats (~$0.04) in one difficulty adjustment period (2,016 blocks/~2 weeks). The implications of being able to earn sats without relinquishing control of private keys is truly a monumental arrival for bitcoin in capital market terms, no matter how tiny the amount of interest may seem.

The node operator can choose to leverage its profitability by advertising a historical rate of return. The node from the example promises depositors a rate of return of 0.15% because a 0.25% return on routing would ensure a positive profit margin. The investor takes counterparty risk because the node could instantaneously exit scam with the depositor’s money or simply fail to deliver on its promise to pay a rate of 0.15% on invested capital. The node, however, is instead motivated by creating a strong reputation as a counterparty and repays all depositors the promised rate to establish creditworthiness and increase the potential for additional deposits. The routing income accrues to the node in a trustless way, but the depository relationships occur entirely off-chain in trusted counterparty situations. The bitcoin era Lightning Network bank, without barrier to entry, available to anybody with the appropriate hardware and software, has arrived. Many will route, profit, succeed, raise deposits, fail, mislead, overpromise, and default, all essential components to a healthy and functioning capital market.

Proposal #3: Lightning Network Reference Rate

Lightning Network transitions bitcoin to a more capital market oriented asset. Hashed Timelock Contracts (HTLCs) combine some of the protocol’s most powerful features into a standardized financial agreement with defined optionality and expiry, allowing participants in the Lightning Network confidence to transact bitcoin without the burden of continuously auditing individual clauses. In theory, the HTLCs in Lightning Network provide bitcoin with its own native risk-free asset (aside from cold storage and HODLing, see Risk Spectrum section), which is a theoretical term in traditional finance used to describe the asset bearing the lowest possible risk within an investment universe. The US Treasury’s obligations carry this label in US Dollar capital markets, and like bitcoin held in Lightning payment channels, have materially less risk than other counterparties. Bitcoin held in Lightning payment channels should serve as a low-risk alternative to off-chain lending and can be used as a reference transaction by which to measure risk premium.

If Lightning node operators around the world disclosed enough NAR data to establish a statistically significant average, this average rate could serve the purpose of offering the bitcoin capital market an accurate measure of low-risk time value. Example: hundreds of nodes disclose NARs, and a cluster of rates is observed around 0.18%. The rate can be a cluster, average, or median of publicly disclosed NARs taken each block or daily, and the end result would be a reference rate widely disseminated to all Lightning Network participants. The Lightning Network Reference Rate (LNRR) can be a very powerful signal that bitcoin has a native time value, a rate that risky off-chain lending should theoretically exceed. If LNRR is equal to 0.18%, an exchange offering 6% on deposits is actually offering a rate of LNRR+5.82%. LNRR represents the time value of the transaction and 5.82% represents its risk premium.

Investors can lend money to the US Treasury at 2.5%, or they can lend to investment grade (IG) corporations at Treasuries plus 1% or junk grade (HY) corporations at Treasuries plus 4%. Investors don’t look at the IG and HY companies as investment opportunities yielding 3.5% and 6.5%; they strip away the Treasury component (time value of the US Dollar) to determine relative value between credit spreads. The Lightning Network Reference Rate can and should serve a similar function in bitcoin capital markets. Exchanges wouldn’t be offering deposit rates at 6% or 8.5% but instead at LNRR+5.82% or LNRR+8.32%.

The Goal is Reserve Currency Status

Reserve currencies need deep and liquid capital markets. Investments denominated in bitcoin exist only on a small scale, largely because bitcoin is still mostly a commodity and costs resources to store and use as opposed to other assets that accrue positive time value. Lightning Network officially switches the equation for bitcoin but is still a nascent technology. For bitcoin to continue its journey toward becoming a world reserve currency, theoretical financial frameworks such as time value, risk premium, and optionality have to evolve but without relying too heavily on legacy ideas and ideals. The primary reason for this proposal is to offer an opportunity for bitcoin to capture relevant characteristics from traditional capital markets and transform them into native and emergent bitcoin financial theory.

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Abstract

I present a three part proposal for Lightning Network node operators. The first and most crucial part of the proposal is a node-level calculation standard for the accrual of satoshis. The Node Accrual Rate (NAR) is offered as a formula to calculate the profitability of an individual Lightning node, expressed as an annualized interest rate.

The second part of the proposal is to convince Lightning node operators to disclose their NARs to each other. Transparency and financial disclosure are core tenants of capital markets, and the disclosure of NARs could correspondingly push bitcoin forward on its path to becoming a more robust asset class.

The third and final part of the proposal is to advocate a framework in which NARs across the network can be aggregated, averaged, and reported as one rate called the Lightning Network Reference Rate (LNRR). LNRR can pave the way for a world of relative value calculations and be instrumental in the pricing of off-chain bitcoin lending.

This is not a proposal for any changes to Lightning Network itself, nor a call for all nodes to share fee accrual data. Nodes will elect for themselves whether or not to share data, and most will likely choose not to do so. The formula is merely a suggestion for developers trying to capture the economics of payment routing.

The Time Value Layer

The Lightning Network sets up a framework from which we can calculate the time value of bitcoin. Interest rate calculations must have three known inputs: principal, income, and time. In Lightning terms, a node opens channels with other nodes and broadcasts the channel opening, essentially locking up principal for a predetermined amount of time. Assuming incoming channels are also opened to the node, the node is now positioned to route payments and charge fees for doing so. These routing fees can be considered income. The ending calculation can be expressed in many ways, but through time node participants will elect standards around which to coalesce. This proposal is a starting place for the discussion around these standards. If multiple standards emerge, I would view this as a positive development because competing calculation standards would foster deeper study of Lightning Network routing economics.

Lightning Network is also an optionality layer. Optionality is relevant to Lightning because it serves to offset one of the primary risks undertaken by Lightning node operators: malicious counterparty risk. Nodes carry the risk of their channel counterparts broadcasting a previous channel state, but this risk is theoretically negated by embedded call options which become executable upon malicious activity. The settlement optionality simultaneously serves as a security enforcement mechanism and a velocity accelerant.

Proposal #1: Node Accrual Rate

I propose the idea of a Node Accrual Rate (NAR) for individual Lightning nodes that desire a standardized method for calculating their realized interest rates. Nodes should be able to automatically calculate their rate of return on capital allocated to facilitate Lightning Network payment routing. Rates can be calculated by querying observable data available in their lnd, c-lightning, or Eclair clients. The following is a proposal for one way to calculate the rate using a generic formula for compounding interest and adapting for block time. The node data can be sliced and diced dozens of logical ways, and I look forward to many counterproposals that are sure to include innovative ways to capture return data.

NAR = [(p+f)/p]^(52,560/n)-1

Let n = the measurement period, expressed in number of blocks, suggested minimum value of 100

Let p = node’s average balance held in channels over the measurement period, expressed in satoshis

Let f = total routing fees earned by the node over the measurement period, expressed in satoshis

52,560 is the approximate number of blocks per year to normalize NAR as an annualized rate

n:

The suggested 100 block minimum measurement period is arbitrary but matches the minimum block time before mining rewards become spendable. Said another way, your Lightning node should be active a certain number of blocks in order to reasonably measure an annualized rate of return. I believe this minimum can be increased to cover at least one full difficulty adjustment period of 2,016 blocks once routing activity becomes more commonplace. A longer minimum measurement period would make for higher quality and less noisy data.

p:

The average balance of a node throughout time can be measured a multitude of ways. Striking channel balances upon each new block confirmation and then averaging these amounts over the measurement period could be a clean and impartial way to determine p.

f:

Lightning Network node operators are already sharing f with each other. I’ve seen numerous “day_fee_sum” screenshots on Twitter with positive integers next to them. Accelerated adoption of the Lightning Network over the past few months brought time value to bitcoin in a trustless way, and nodes are earning sats as a result. Node operators already sharing f with each other will soon be calculating and sharing their NARs as well.

Proposal #2: Disclosure of NARs

Lightning node operators currently volunteer information about collecting routing fees, managing payment channels, and other emergent routing techniques. In a similar way, I anticipate and strongly encourage nodes to volunteer their NARs. Sharing NAR data is an easy way to display profitability to other capital market participants. The exchange of profitability information is a foundational tenant of capital markets; the widespread exchange of NAR data between nodes would accordingly bring long term health to bitcoin’s capital market. Node operators are already disclosing the small amount of sats they’ve earned by routing payments through the Lightning Network, leading me to believe that such NAR exchanges will be commonplace for nodes motivated by profit or by transparency. Some nodes will look to attract capital in order to leverage their newfound skill set, even though most nodes will not be motivated to share data. Some nodes will be dishonest about their NAR, and the market will have to identify fraudulent disclosures just as forensic accountants dissect every disclosure from publicly traded corporations.

Advertising profitability, even if unaudited, will attract capital looking for return. Example: a Lightning node with sufficient capital and well positioned inbound and outbound payment channels earns a NAR (annualized return) of 0.25%. Funded with 10 million sats (0.1 bitcoin/~$400), the node earns about 957 sats (~$0.04) in one difficulty adjustment period (2,016 blocks/~2 weeks). The implications of being able to earn sats without relinquishing control of private keys is truly a monumental arrival for bitcoin in capital market terms, no matter how tiny the amount of interest may seem.

The node operator can choose to leverage its profitability by advertising a historical rate of return. The node from the example promises depositors a rate of return of 0.15% because a 0.25% return on routing would ensure a positive profit margin. The investor takes counterparty risk because the node could instantaneously exit scam with the depositor’s money or simply fail to deliver on its promise to pay a rate of 0.15% on invested capital. The node, however, is instead motivated by creating a strong reputation as a counterparty and repays all depositors the promised rate to establish creditworthiness and increase the potential for additional deposits. The routing income accrues to the node in a trustless way, but the depository relationships occur entirely off-chain in trusted counterparty situations. The bitcoin era Lightning Network bank, without barrier to entry, available to anybody with the appropriate hardware and software, has arrived. Many will route, profit, succeed, raise deposits, fail, mislead, overpromise, and default, all essential components to a healthy and functioning capital market.

Proposal #3: Lightning Network Reference Rate

Lightning Network transitions bitcoin to a more capital market oriented asset. Hashed Timelock Contracts (HTLCs) combine some of the protocol’s most powerful features into a standardized financial agreement with defined optionality and expiry, allowing participants in the Lightning Network confidence to transact bitcoin without the burden of continuously auditing individual clauses. In theory, the HTLCs in Lightning Network provide bitcoin with its own native risk-free asset, which is a theoretical term in traditional finance used to describe the asset bearing the lowest possible risk within an investment universe. The US Treasury’s obligations carry this label in US Dollar capital markets, and like bitcoin held in Lightning payment channels, have materially less risk than other counterparties. Bitcoin held in Lightning payment channels should serve as a low-risk alternative to off-chain lending and can be used as a reference transaction by which to measure risk premium.

If Lightning node operators around the world disclosed enough NAR data to establish a statistically significant average, this average rate could serve the purpose of offering the bitcoin capital market an accurate measure of low-risk time value. Example: hundreds of nodes disclose NARs, and a cluster of rates is observed around 0.18%. The rate can be a cluster, average, or median of publicly disclosed NARs taken each block or daily, and the end result would be a reference rate widely disseminated to all Lightning Network participants. The Lightning Network Reference Rate (LNRR) can be a very powerful signal that bitcoin has a native time value, a rate that risky off-chain lending should theoretically exceed. If LNRR is equal to 0.18%, an exchange offering 6% on deposits is actually offering a rate of LNRR+5.82%. LNRR represents the time value of the transaction and 5.82% represents its risk premium.

Investors can lend money to the US Treasury at 2.5%, or they can lend to investment grade (IG) corporations at Treasuries plus 1% or junk grade (HY) corporations at Treasuries plus 4%. Investors don’t look at the IG and HY companies as investment opportunities yielding 3.5% and 6.5%; they strip away the Treasury component (time value of the US Dollar) to determine relative value between credit spreads. The Lightning Network Reference Rate can and should serve a similar function in bitcoin capital markets. Exchanges wouldn’t be offering deposit rates at 6% or 8.5% but instead at LNRR+5.82% or LNRR+8.32%.

Reserve Currencies

Reserve currencies need deep and liquid capital markets. Investments denominated in bitcoin exist only on a small scale, largely because bitcoin is still mostly a commodity and costs resources to store and use as opposed to other assets that accrue positive time value. Lightning Network officially switches the equation for bitcoin but is still a nascent technology. For bitcoin to continue its journey toward becoming a world reserve currency, theoretical financial frameworks such as time value, risk premium, and optionality have to evolve but without relying too heavily on legacy ideas and ideals. The primary reason for this proposal is to offer an opportunity for bitcoin to capture relevant characteristics from traditional capital markets and transform them into native and emergent bitcoin financial theory.

Further Reading

This is the fourth and final article in the series titled The Lightning Network Reference Rate. Please check out Part 1, “The Bitcoin Second Layer,” Part 2, “The Time Value of Bitcoin,” and Part 3, “The Bitcoin Risk Spectrum.”

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Bitcoin is digital gold, and this continues to be its most appropriate and concise metaphor. I recently discussed some parallels between gold and bitcoin in an article about layered money and Lightning Network. In this writing I’d like to focus on the storage analogy. The capital market of gold relies upon protected, armored, and insured storage vaults around the world. Without a robust vault infrastructure, multi-generational savings held in physical gold would be impractical. Bitcoin, going forward, will be no different. Individuals keep gold secured in their homes, but countries and central banks build vaults. Individuals keep bitcoin private keys on laptops, hardware wallets, or pieces of paper in their homes, but countries and central banks will build vaults. Vaults storing bitcoin private keys have been around for years, but Fidelity recently set an asset management industry precedent that will redefine bitcoin’s custodial infrastructure landscape.

I have peppered this article with over a dozen articles, editorials, and media for anybody looking for a one-stop-shop of deep dive material for bitcoin’s investment case and financial system integration.

The Investment Case for Bitcoin

The investment thesis for bitcoin has reached an incredible level of clarity over the past couple years: bitcoin is officially money’s newest abstraction. Instead of reinventing the wheel, please refer to these particularly fantastic pieces by Vijay Boyapati and Iterative Capital outlining bitcoin’s investment case and an excellent piece by Pierre Rochard thoroughly covering bitcoin’s unique and decentralized governance. As we stand, the wealthiest university endowments are determined to allocate to bitcoin’s ecosystem, and Sovereign Wealth Funds will not be far behind. The legacy asset management industry has finally woken up to the truth: the business of bitcoin private key management has massive pent up demand, and the time to service that demand is now.

But I Just HODL

Many hodlers store their bitcoin themselves and never rely on trusted third parties for custody. These hodlers have financial sovereignty and are free of any counterparty risk. They also have a unique power: they can refuse to sell, limiting available supply at current prices. So why does any of this custodial infrastructure development matter to a hodler? Because the future clients of Fidelity are theoretically short bitcoin. Allow me to explain. I won’t predict a date, but one day major governments and corporations will need to pay for a good or service from a seller that only accepts bitcoin. These institutions will be forced to purchase bitcoin in the open market to make delivery of payment. Therefore, institutions are short a forward bitcoin obligation. The act of them purchasing bitcoin in the future may appear as just a purchase, but in theory it will be covering a short position they’ve had since bitcoin’s rise to global money status became evident. Therefore, hodlers have the power to exacerbate the mother of all short squeezes by not selling.

Private Key Management

How do you store your bitcoin? Is it on a Trezor, and is the Trezor in a safe deposit box at a bank? Where do you write down and keep your passphrase? Do you make your own paper wallets, on what computer did you generate them, and did you make sure the computer was never connected to the internet before and after key generation? Perhaps you employ the services of a company like Casa to help guide you through multi-signature cold storage while still maintaining both custody and full responsibility for your keys. Or perhaps you choose to keep your bitcoin on an exchange. Everybody knows by now that trusted third parties are security holes, and scammers are everywhere. Now, imagine you represent institutional money. You are the Chief Investment Officer for your alma mater’s endowment fund. How would this affect your decision on private key storage? Hopefully, you will be wary of your own ability to properly manage bitcoin private keys and equally wary of an exchange’s ability to do the same.

The Business of Private Key Management

I can comfortably answer many of these storage questions with two sweeping generalizations. Firstly, hodlers of bitcoin will never surrender their private keys and will continue to improve the science and practice of cold storage wallet infrastructure. Secondly, institutions buying real bitcoin (not bitcoin claims) will take delivery of their purchase into institutionalized cold storage solutions provided by well-established and insured asset managers and custodians. An endowment, central bank, or pension fund making its very first allocation to bitcoin will not self-custody due to lack of cold storage expertise. Unlike individuals with an ambition for financial sovereignty, these large institutions will trust third parties, diversify their risk, and buy insurance to protect their bitcoin. There is no company in the world currently better suited to provide this institutional solution than Fidelity.

Fidelity

Fidelity long ago started experimenting with the bitcoin software protocol by spinning up a full node and successfully mining bitcoin. With the release of a phenomenal whitepaper on institutional custody, Fidelity has not only positioned itself as a pioneer in the industry but also as an authority on the emerging bitcoin asset class. The literature released by the new Digital Assets subsidiary displayed an awe-inspiring grasp of the opportunities and challenges when building the custodial infrastructure for bitcoin. Fidelity’s position in the traditional asset management industry is one of modest dominance along with a handful of other firms. The warning shot sent to the rest of the industry with the release of this whitepaper and underlying physical vaulted custodial solution is one that will leave bitcoin’s financial system integration unrecognizable by today’s standards. I cannot stress enough the follow-on effects of Fidelity’s arrival. Bitcoin does not need Fidelity to become legitimate; rather Fidelity launched bitcoin custodial services because bitcoin has already achieved legitimacy.

Next Up

I believe Northern Trust will be the next major industry player to announce a bitcoin physical vault infrastructure and custody solution for its clients sometime in 2019. Goldman Sachs, JP Morgan, State Street, and Bank of New York Mellon will follow, and within just a few years, the entire asset management industry will be involved in the bitcoin ecosystem to some extent. Robust custody infrastructure paves the way for the creation of more investment vehicles such as ETFs and Mutual Funds. Good actors in the industry will have the opportunity to disclose public keys to prove fully-reserved situations. ETFs are inevitable, and I hope to see the SEC specifically approve ETFs that will physically custody bitcoin such as the VanEck SolidX ETF. The SEC must approve bitcoin ETFs that will set lofty industry standards for investment structure, cold storage, cyber security, and insurance. Physically delivered bitcoin futures contracts offered by ICE, one of the world’s largest derivatives exchanges, will settle into ICE’s CFTC regulated Digital Asset Warehouse. ICE’s storage solution may serve as an interim custodian for investors that are actively trading in and out of positions. Not only are all the major industry players already arriving to the party, but also the premise that the US government will somehow ban bitcoin is becoming increasingly foolish.

Becoming a Major Asset Class

The price of bitcoin in the future will be a function of how much of the world’s wealth finds its way into the limited supply of 21 million bitcoin. With a total market capitalization today of just over $100 billion, bitcoin still appears only as a tiny grain of sand relative to the more than $100 trillion in financial assets held at the previously mentioned custodians. With new rails from the $100 trillion asset base to the nascent $100 billion bitcoin economy, bitcoin’s network effects, discussed eloquently by Trace Mayer, will strengthen drastically. As investors reallocate their current investment portfolios to include bitcoin, trillions of dollars in market capitalization appreciation becomes an inevitable result, a scenario beautifully laid out by both Tuur Demeester and Murad Mahmudov. Endowments and Sovereign Wealth Funds do not want to be late to this massive reallocation event, but neither will forward-thinking governments and central banks. Infrastructure for these investor types has arrived: let the digital land grab ensue.

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Image source

Financialization

Let’s get one thing straight before we dive into the financialization of bitcoin: bitcoin doesn’t need any ETFs or legacy custodians in order to survive. In fact, bitcoin thrives because it didn’t closely interact with traditional financial institutions in its early years and thus cemented its decentralization. The relationship between bitcoin and traditional financial institutions, however, is about to change in a big way. It’s worth taking a step back and assessing some pros and cons, as well as strategize the ideal outcome for bitcoin so that the 21 million supply maximum isn’t diluted by a fractionally reserved overabundance of claims masquerading as real bitcoin.

I know there are many owners of bitcoin that will never relinquish the responsibility of private key management to a trusted third party; I am one of them, and I encourage everybody to practice private key management. Unless you do so, you don’t own real bitcoin. But institutions will not choose this route. They will use custodians, ETFs, and insurance. These solutions are layers on top of bitcoin that carry significant counterparty risk. Bitcoin’s integration into the traditional financial system of counterparty risk is arriving as we speak.

Fast Money versus Real Money

Fast money and real money are generic terms used to describe two distinct investor types in the asset management industry. Fast money generally refers to billion dollar hedge funds, some of which are already dabbling in bitcoin. These funds are likely using exchanges for custody, although some might be using robust multisignature self-custody solutions. These investors are hopefully quite familiar with the risks of owning bitcoin as a claim given past exchange hacks.

Real money encompasses over a hundred asset managers with at least $100 billion under management, including a dozen with over $1 trillion each, absolutely dwarfing the size of fast money. Real money managers act as fiduciaries for governments, central banks, and corporations. These clients have strict investment guidelines and thick bureaucracy preventing short-term flexibility of investment strategy. They have quarterly board meetings and countless consultants that slow down the investment decision-making process. They do extensive review of all counterparties and use large custodians such as State Street, Bank of New York Mellon, and Northern Trust to house their assets. My experience in the asset management industry tells me that institutional investors will use current financial rails to access bitcoin. They will entrust the purchase and storage of bitcoin to third parties that demonstrate expertise. They do not custody bonds and equities themselves, and they won’t do so with bitcoin either. They will hire custodians that have robust insurance mechanisms against loss and theft. Hopefully, and most importantly, they will hire custodians offering verifiable NAVs.

Verifiable NAVs

Net Asset Value describes the value of underlying assets in an investment vehicle. For example, if a fund owns 1,000 BTC for its investors, its NAV would be $6.7 million assuming a price of $6,700 per bitcoin. But how does somebody owning shares in this fund know that the balance of 1,000 BTC is real? There is one way: the fund discloses its public keys to investors on a regular basis. This would allow the public to observe, but not spend, the fund’s holdings. If investment vehicles continuously disclosed public keys and developed a reputation of doing so honestly, we would see a huge leap forward in the relationship between bitcoin and traditional financial institutions. I do believe that in addition to fraudulent fractionally reserved custodians, good actors will disclose public keys in an honest and transparent way. I specifically encourage Bakkt and VanEck, two entities that have recently announced products that will require private key management, to prove to the highly scrutinizing public that bitcoin holdings are genuine and bitcoin claims are fully reserved. Owners of bitcoin and fully validating node operators must hold Bakkt’s and VanEck’s feet to the fire and demand maximum possible transparency.

ETFs

The growing probability of an eventual bitcoin ETF approval from the SEC has brought out some strong opinions from owners of bitcoin. I’ll quickly summarize the two primary fears expressed. Firstly, some are opposed to ETFs because bitcoin is designed to provide people with financial sovereignty, and any display of third party reliance is unwelcome. This argument ignores the fact that millions of people already hold their bitcoin on exchanges and therefore only own claims on bitcoin and not real bitcoin. Secondly, some are opposed to ETFs because of fears of fractionally reserved bitcoin and artificial supply inflation. This is a valid fear and theoretically can never be assuaged. ETF managers can do only one thing to convince the market they are good actors: verifiable NAVs via public key disclosure. It is important to remember that an ETF manager can still get hacked or mismanage private keys, a risk that will likely be insured by yet another counterparty. I anticipate ETFs will be used by both retail and institutional investors. Retail investors can invest through their already-established brokerage accounts; institutional investors generally already have allocations to a variety of equity ETFs and have a high degree of familiarity with the asset type.

Custodians

Institutional investors looking for increased privacy and control will elect to hold bitcoin at an established custodian rather than invest in an ETF. This type of activity will be reserved for investors that prefer to have a single counterparty separating themselves from their bitcoin (ETF investors are two counterparties removed from their bitcoin because they own shares in a trust that stores bitcoin). Typically, large institutional investors will hire asset managers to structure portfolios and will separately hire a custodian to house those assets. The relationship between the institution and custodian is independent from the relationship between institution and asset manager. For example, let’s say a central bank wants to purchase bitcoin but doesn’t have the necessary infrastructure or expertise yet to hold bitcoin in cold storage. The central bank will hire two separate entities, a broker and a custodian. The broker will source the bitcoin and deliver to a public key provided by the custodian on behalf of the central bank. The central bank only has counterparty risk to the custodian going forward. I believe that large institutions will eventually choose this method of buying and storing bitcoin over ETF purchases to reduce, but not eliminate, counterparty risk. The custodians will have an immense responsibility of security and a fiduciary duty to protect the client’s private keys at all costs. Custodians may choose to comingle bitcoin balances or they may choose to keep the bitcoin allocated in specific public keys corresponding to individual clients. For heightened transparency, they should choose the latter. I am unaware of any large traditional custodian offering bitcoin custody services at the moment, although announcements from Fidelity, Northern Trust, and Goldman Sachs over the past several months suggest that bitcoin custodial services by traditional finance might be only a year or two away.

Collateral and Securities Lending

Once custodians and ETFs have custody of large quantities of bitcoin, they will have powerful collateral in their hands. In the traditional financial system, US Treasuries are considered pristine collateral. For example, if a company owns US Treasuries and needs to unlock liquidity to invest in a project, it can post the Treasury as collateral to a bank and borrow against it. If the company defaults on the loan, the bank is indifferent because they hold the Treasury as collateral and can just sell it to recoup their money. Bitcoin can be used as collateral in a similar manner. Companies such as BlockFi are taking bitcoin as collateral and lending US Dollar liquidity against it.

Institutional investors should demand that custodians don’t use allocated bitcoin as collateral to borrow money without explicit authorization. If a custodian defaults on a loan secured by a client’s bitcoin, the client won’t recover its holdings. Clients however can choose to allow custodians to conduct such activity to earn some extra return, a process traditionally called securities lending. Institutional investors need to be made aware of the risks of bitcoin lending by custodians in the context of traditional securities lending. This type of activity again can be policed by a system of public key disclosure by the custodian and monitoring of bitcoin’s blockchain by the investor. Investors should run watch-only full nodes just to continually audit their custodian.

Conclusion

Institutional investors will not be engaging in private key management for their bitcoin allocation for many years to come. Custodians and ETF managers that have been investing time and money in bitcoin education and infrastructure will hold private keys on behalf of clients. I envision a scenario in which custodians and ETFs might become some of the largest holders of bitcoin in the world, necessitating a continuous and rigorous audit process by anybody interested in the sanctity of bitcoin’s 21 million supply cap.

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Assets Under Management rankings can be found at https://www.ipe.com/Uploads/k/x/x/Top-400-Ranking.pdf

Bitcoin’s antifragile protocol and its exponentially increasing network effects make it a behemoth, gradually swallowing up global economic activity. The latest of these network effects is a second layer protocol called Lightning Network, which uses bitcoin’s base layer protocol as its security. The concept of layered money is not new in monetary history. In this writing, I’ll be using gold as an analogy to describe why bitcoin will evolve in layers on its way to world reserve currency status.

Layered Money

Gold has served as money for millennia due to its unique chemical properties and its global network effects. But gold has not acted as money only in its raw physical form, or on its first layer. Gold is a perfect example of how a layered money system evolves. Let’s take a look at gold as money in a four layered example. I’ll describe the rule set, or protocol, of each gold layer so the reader can imagine similarities to bitcoin’s layered protocol approach.

The first layer of gold is the physical gold in its raw form after it is mined: gold nuggets. The protocol of gold’s base layer has only one rule. The element must adhere to the properties of the periodic table’s 79th element. If it does, it is gold; if it does not, it is not gold. Consensus around this “79th element” protocol is millennia old.

The second layer of gold is raw gold that has been melted and shaped into bars and coins following a standardized protocol of purity, weights, and measures. Mints can be controlled by governments or by private enterprise, but the coinage will only be considered money by users if the “79th element” first layer protocol is followed.

The third layer of gold is gold certificates. These are claims issued by banks that have taken gold on deposit. Third layer banks will only use gold coins and bars that follow the consensus second layer protocol of purity, weights, and measures and only from mints that are properly following the “79th element” protocol. These certificates can act as money but carry counterparty risk of the issuer.

The fourth layer of gold is certificates backed by bank-issued gold certificates. A liquidity provider can issue these certificates, which would require several layers of trust by the user. Somebody accepting fourth layer gold as money has to trust that the liquidity provider has real gold certificates, which are backed by physical gold at a bank that follows a standardized purity for gold deposits.

Each layer uses the layer beneath it for consensus and security. Money will always see a multiple layered expansion as it evolves, and each layer has costs and benefits. You can mine your own gold, but this process is very expensive with a high barrier to entry. You can buy gold coins and bars easily in most parts of the world, but using them for day to day commerce is unfeasible. As a merchant, you can accept gold coins but either have to trust the purity or assay the gold yourself. Once you’re using the paper certificate layers, you now are engaged in counterparty risk, but have easier capacity for transactions. Each layer serves a different function. Base layers are for final settlement, while higher layers are for facilitation of economic activity.

Bitcoin’s First Layer

Bitcoin’s first layer, or base layer, is a protocol proposed in 2008 that has reached a global state of consensus as it approaches its tenth birthday. Bitcoin’s unit of account, also called bitcoin, has exchange rates with currencies around the world in markets that are growing in depth and liquidity. The protocol itself has added vital updates in its young life that have strengthened both security and usability. The network’s uptime and its ability to prevent double spends are relentless.

Critics of bitcoin often incorrectly identify a feature of bitcoin, its slow speed, as a flaw. Bitcoin’s confirmation process is meant to be slow because of security reasons. The intent of bitcoin is censorship-resistant, scarce digital cash, not a speedy payments solution. The best way to think about bitcoin’s base layer protocol is as a final settlements layer. The final settlement of physical gold is also a slow, clunky, and expensive process. Imagine, for example, companies in different parts of the world settling large balances of gold by loading ships with physical gold bars and sailing fortunes hundreds of miles across seas. Not only is the delivery an arduous process, but the verification process is also quite a task. In theory, every single piece of metal would have to be tested for purity. This process should be considered as historical context for what is required to have true final settlement of scarce money. The energy consumption required to find valid blocks has dramatically increased over time which increases security, but difficulty adjustments ensure bitcoin still averages six blocks per hour.

Centralization and attack vulnerability, while both permanent concerns to owners of bitcoin, have not prevented huge sums of capital to be stored in bitcoin’s denomination. The denomination, commonly known as BTC, despite its commonly quoted exchange rates with fiat currencies, stands alone as a final settlement asset. With a secure and reliable final settlement layer firmly in place, development of higher layers can ensue: enter the Lightning Network.

Bitcoin’s Second Layer

Lightning Network is a second layer protocol on top of bitcoin. The protocol uses bitcoin as its native denomination, meaning that Lightning can only be used by those with real bitcoin. Under the hood, Lightning Network is a web of bidirectional payment channels, but the protocol’s functionality is beyond the scope of this writing. The important takeaway is that Lightning allows for the instantaneous transfer of bitcoin from peer to peer with one considerable difference from the first layer: channel balances can adjust but do not require immediate settlement on the base layer. Simply stated, Lightning transactions are unsettled bitcoin transactions.

Having unsettled bitcoin comes with risk, however. Bitcoin held in Lightning Network payment channels can be stolen by malicious actors if node operators are not properly monitoring the channels and the base layer. Malicious actors have a strong disincentive to steal, however, as fraudulent activity gives the victim ability to sweep all funds from the channel. Now that we have covered some of Lightning Network’s basics, let’s take a look at the importance and the significance of this new layer on top of bitcoin.

The Importance of Lightning

Firstly, the Lightning Network is a zero sum, fully reserved routing network. You may only use Lightning if you bring in real bitcoin, and all routing fees earned by liquidity providers are paid for by liquidity consumers. This allows Lightning Network to operate with one of the primary features of bitcoin, its limited supply.

Secondly, Lightning does not carry the burden of base layer confirmation. This allows for bitcoin to be exchanged ad infinitum without consuming precious block space. Lightning nodes can decide to take final settlement of their bitcoin by broadcasting the correct state of a payment channel to the base layer at any time, but they don’t have to.

Lastly, Lightning transactions can be interpreted as financial agreements, making Lightning Network a capital market layer. The network’s structure is built as a market for capital and liquidity. Bitcoin can now instantaneously fly around the world without having to wait an hour for final settlement. The two core components to any financial transaction, time value and risk premium, can be derived from Lightning transactions. Opportunity cost tradeoffs can be calculated, and bitcoin can be leased on a short term basis to the network without surrendering one’s private keys. With gold, there is no way to accrue positive interest on capital without surrendering the physical metal. This makes Lightning Network an absolute game changer for the entire concept of capital markets: income without explicit counterparty default risk.

Conclusion

Bitcoin is often referred to as digital gold, but I’ll propose a more specific analogy. Bitcoin’s base layer is like digital physical gold, while Lightning Network is like digital paper gold but without the counterparty risk. The second layer is unsettled and less secure, but infinitely more usable. Bitcoin is incredible at censorship resistance and decentralization, but frankly terrible at speed and efficiency. Critics of bitcoin completely miss the fact that speed and efficiency should take place on higher layers, NOT on the base layer. Lightning’s arrival will show the world bitcoin’s true capabilities. If gold could only be used as a physical metal, global economic activity would have been prohibitive on a gold standard. Thankfully, paper gold satisfied the liquidity and capital market layer. Lightning Network ensures bitcoin’s path to global reserve currency because it makes bitcoin come alive. Once bitcoin can be transacted around the world without the constraint of a slow confirmation process, it can graduate from reserve asset to reserve currency. Lightning Network finally frees bitcoin from its base layer shackles.

Further Reading

This article is a prelude to my previous work. I have decided to make this article Part 1 of 4 in my series “The Lightning Network Reference Rate.” Please also check out the second and third parts of this four part series. In Part 2, “The Time Value of Bitcoin,” I introduce the concept of LNRR, or the Lightning Network Reference Rate. In Part 3, “The Bitcoin Risk Spectrum,” I discuss the reasons why LNRR can be a monumental innovation for bitcoin denominated capital markets. Part 4, coming soon, will be titled “The Lightning Network Reference Rate.”

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Andreas posted he is making 4204 fees/week on his node, which he put $325,000 on. (week_fee_sum”: “4204”). My node has $7,500 which is about 40x less, but I’m making almost 2x his weekly fees. (“week_fee_sum”: “7829”). Why do I make more with less? Capital isn’t the only factor.

@alexbosworth

https://twitter.com/alexbosworth/status/1019985943321706496

I organized his information into a table and provided some conversions and calculations given the data provided. The three variables required to calculate interest are present in his tweet, giving us an exciting first opportunity at measuring the on-chain time value of bitcoin. The variable “week_fee_sum” contains income and time, and the principal is given in US Dollars. I assumed a BTC/USD price of $7,400.

Conversions and Calculations

1. Converted the given principal (USD) to satoshis.

2. Divided fees/week (satoshis) by principal (satoshis) to attain the weekly return on each node.

3. Converted the weekly rate into an annualized rate by compounding the weekly rate 52 times.

4. Converted the given fees/week (satoshis) into USD.

5. Divided fees/week (USD) by principal (USD) to double check the previous interest rate calculation; the interest rates matched, as expected.

6. Divided fees/week (satoshis) by 1,008 (blocks/week) to attain the average fees/block as another way to observe the data.

Observations

1. The first and most important observation from the data is that Alex Bosworth is showing an annualized return of 0.40% which is material income, especially in an low global interest rate environment. I am pleasantly surprised and believe this number will turn a lot of eyes.

2. The disparity of returns between Alex’s and Andreas’ nodes is enormous. Alex’s interest rate is 80 times Andreas’s rate! Because we only have two data points, we don’t know if these interest rates are high, low, or average relative to the rest of the network.

3. I believe the integrity of the data he provided, but we weren’t given a way to verify it. I believe a mechanism to verify another node’s stated interest rate is crucial to open capital markets.

4. Notice that he volunteered this information despite it being private and proprietary to his node. This is common in capital markets; for example, a company that discloses its financials to secure funding from investors. Alex is advertising his skill and will likely attract investors seeking a positive interest rate on their bitcoin. This is how on-chain time value calculations can lead to off-chain capital markets.

5. I chose to express fees as satoshis/block as an additional way to think about performance between the two nodes. While the number is informative, it doesn’t account for the principal it took to earn that amount and is therefore not an interest rate.

6. His final sentence, “capital isn’t the only factor,” is meant to point out that skill is a driver of returns. Skilled Lightning node operators will drive competition, and node management techniques will evolve and improve as a result.

Conclusion

A very big thank you to Alex Bosworth for volunteering this incredibly valuable information on the economic performance of his Lightning node. We are in the early stages of calculating time value and risk premiums using Lightning Network’s framework. I’m optimistic that Alex will set a trend by publishing his Lightning interest rate, even though he didn’t express it in those terms. Discussions about LNRR and its role can wait until more research is done on individual Node Rates.

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Follow Alex at https://twitter.com/alexbosworth

Lightning Network

HTLCs are financial agreements with two important properties that eliminate reliance on trusted third parties. Firstly, the contracts have an embedded call option on the counterparty’s bitcoin which dissuades theft. Secondly, the contracts have an expiration, which prevents balances to be held in limbo to perpetuity. These two properties remove counterparty risk but instead introduce payment channel management risk. Routing Lightning payments is the equivalent of a short-term bitcoin lease and allows the router to earn fees; these fees can be used to calculate interest earned on bitcoin staked to Lightning payment channels.

Traditional Capital Markets

Traditional capital markets have a risk spectrum: generally speaking, higher variance of returns is positively correlated with a higher expected return. More risk, more reward. It is important to note that risk-free rates are entirely conceptual and theoretical. They are simply a matter of convention to facilitate financial theoretical research and improve communication. Therefore, this article is an attempt to discuss and derive bitcoin-native financial theory, including how bitcoin can be reconciled against other assets. Bitcoin is still trillions of dollars of market capitalization away from becoming a legitimate alternative to other deep capital markets like the ones denominated in US Dollars, Euros, Yen, Pounds, and Yuan. Before we dissect bitcoin’s risk spectrum, let’s take a look at that of the US Dollar to get a sense of which aspects bitcoin should copy and which it should reinvent.

US Dollar Risk Spectrum

Why is the US Dollar the world’s reserve currency? There are many reasons including geopolitical and economic prowess, but one of the reasons is the depth of its capital market. There are over $100 trillion in bond and equity securities, allowing owners of US Dollars to easily find a home for them. Its capital market can be viewed as a risk spectrum, with risk on the x-axis and expected return on the y-axis.

The first point (illustrated) on the risk spectrum is US Treasury debt. Financial theory requires a risk-free asset to establish baseline interest rates, and currently that asset is US Treasuries. The obvious flaw of this financial theory is that US Treasuries are not truly risk-free. They have default risk, albeit appropriately characterized by market as the lowest possible default risk that an investor can attain. (Many sovereign bonds now have yields lower than yields in the United States, but those bonds are not denominated in US Dollars. This article is written only comparing bitcoin to the US Dollar).

The second point is corporate bonds. Companies issue fixed obligations at a spread to US Treasuries; for example, this year Walmart issued a 5yr bond at 5yr Treasuries plus 0.60% and General Motors issued a 5yr bond at 5yr Treasuries plus 1.37%. Each of these companies used the 5yr US Treasury as a reference rate. Investors consider the risk premium, or creditworthiness, of each company relative to Treasuries. We can see from this example that bond investors view Walmart as more creditworthy than General Motors because Walmart borrows at a lower spread to Treasuries. This is why reference rates are considered an anchor for debt capital markets, because they more easily allow for relative value comparisons.

Further along the risk spectrum are investments with higher risk profiles, such as publicly traded equities and venture capital funds. Theoretical formulas for the expected return on equities usually include a combination of the risk-free rate and the company’s risk premium. Venture capital investors will seek an even higher return because the probability of principal loss is perceived to be higher than that of public equities. Theoretical risk premiums are added to each subsequent point of the risk spectrum, all anchored from the risk-free rate.

Bitcoin Risk Spectrum

Bitcoin’s capital market should be designed from first principles because its final settlement does not require trusted third parties. Final settlement of the US Dollar has counterparty risk because deposits are considered a liability on banks’ balance sheets. Holders of US Dollars would rather face the US government as a counterparty rather than banks, so they prefer to purchase US Treasuries with their deposits. Either way, the final settlement has counterparty risk. Additionally, the US Dollar itself depends on a single nation and has a single entity controlling monetary policy in a discretionary way; bitcoin avoids both of these risks. Let’s take a look at Bitcoin’s risk spectrum.

The first point (illustrated) on Bitcoin’s risk spectrum is bitcoin held in cold storage. The analogy commonly used for cold storage is a gold bar held in your hand. There is no counterparty risk; the risk is its storage and security, much like if you had possession of physical gold. Skilled storage and security practices make loss less likely, and the advent of robust multisignature solutions further reduces risk. Private key management anchors the bitcoin capital market much like the timeliness and consistency of the US government paying back its debt obligations anchor the US Dollar’s capital market. The expected return on cold storage bitcoin is at best zero and is actually negative if you consider that storage costs and on-chain transaction costs are non-zero.

I am proposing that the second point on Bitcoin’s risk spectrum should be LNRR, the Lightning Network Reference Rate. Routing fees earned on bitcoin staked to Lightning payment channels can be expressed as an interest rate. The rates received on the payment channel or node level can be hashed and cryptographically provable. Node operators can opt-in to publish realized interest rates on their capital. If a consensus can be reached on an interest rate calculation protocol, capital providers can publish interest rates in an open and transparent way. Positive interest rates will attract bank-like entities that believe they can earn positive return using effective payment channel management and security techniques. Some bitcoin previously held in cold storage will seek the income attainable in Lightning Network, the first ever example of an opportunity cost tradeoff in bitcoin that doesn’t require additional counterparty risk. Bitcoin staked to Lightning is the most unique income producing asset in all of monetary history: income with zero counterparty risk. The historical implications of this on capital markets are tremendous.

A huge leap in risk exists between the second and third point on Bitcoin’s risk spectrum. The first two points, as we have established, have various security and management risks but no counterparty risk whatsoever. Real world lending of bitcoin has genuine counterparty risk, whether using exchange-based lending platforms or other forms of direct lending. In theory, these rates of borrowing should be higher than LNRR, and capital providers could use LNRR to make relative value decisions between bitcoin leasing via Lighting and off-chain bitcoin lending. Any real world lending will not have bitcoin’s blockchain as security. Lenders will need strong contracts in jurisdictions with strong rule of law to ensure repayment of capital, just as they do with fiat currencies. Complete loss of principal remains.

Conclusion

I am increasingly optimistic that we are close to seeing Lightning Network wallets provide a way to calculate interest earned via routing fees. Lightning development is accelerating and the total bitcoin staked to payment channels is increasing accordingly. The time value calculations that we are on the verge of realizing will underpin the entire bitcoin capital market. It will not happen all of a sudden. Node operators will need to cryptographically prove interest earned over a long enough time horizon to attract larger sums of capital to Lighting Network. Wallet infrastructure and security both still need a lot of improvement, especially as UX leaves the command line and enters the GUI phase. I am eager and excited to hear from the Lightning community on how we can achieve the first step on the path to reserve currency: interest rate and time value calculations.

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tl;dr

The HTLCs in Lightning Network give bitcoin a path to become a global reserve currency.

Abstract

Lightning Network provides a framework to measure the time-value of bitcoin, a precursor for a capital market and reserve currency status. Observable variables in Hashed Time Locked Contracts can be used to calculate the interest rate received on bitcoin held in payment channels, allowing investors to measure their opportunity cost of capital. Lightning Network wallet software should include ways to calculate interest and prove the rate received in a trust-minimized way. A reference rate should be developed akin to US Dollar LIBOR, using consensus to dictate how the rate is calculated. This reference rate can anchor off-chain bitcoin lending into the global economy, leading to bitcoin-denominated banks, credit ratings, debt capital markets, and eventually an entire financial system: a path toward status as a global reserve currency.

Calculation Method

Three observable variables are needed to calculate an interest rate: principal, cash flows, and time. In Lightning Network, the principal is the amount of bitcoin in a payment channel; cash flows are routing fees; time is the block-time in which the fee collection is measured. Wallet implementations should experiment with different interest rate calculation methods with the eventual goal of a consensus method. The US Dollar has Treasuries, Fed Funds, LIBOR, OIS, and SOFR all acting as reference rates within the capital market for lending, borrowing, and swapping cash flows. Bitcoin needs to establish a reference rate of its own, referred to in this writing as LNRR (Lightning Network Reference Rate).

There are many possible ways to calculate LNRR. Principal may be measured once per block or using an average over time. Fees may be measured for individual HTLCs, individual payment channels, or Lightning Network nodes with multiple channels. Block-time may be measured by the locktime of HLTCs or measured one block at a time. Compounding conventions may be discrete or continuous. On-chain fees paid to open and close channels may be included or excluded in the calculation. We need to experiment with calculation methods because bitcoin is an entirely new asset class and shouldn’t adhere to financial conventions of the past, even though traditional fixed income markets set the bar extremely high for financial sophistication.

Time-value of bitcoin

Fees, time-value, and security risk premiums are discussed in the The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments by Joseph Poon and Thaddeus Dryja:

The time-value of fees pays for consuming time (e.g. 3 days) and is conceptually equivalent to a gold lease rate without custodial risk; it is the time-value for using up the access to money for a very short duration.

Historically, one of the largest component of fees and interest in the financial system are from various forms of counterparty risk — in Bitcoin it is possible that the largest component in fees will be derived from security risk premiums.

Fees in Lightning Network can be attributed to two components, time-value and security risk premium. Fees compensate the leasing of bitcoin which translates into time-value. Positive interest rates should attract capital and competition. But Lightning Network node operators investing capital are not doing so purely risk-free. They are taking on a variety of risks, most notably the risk of using hot wallets to stake liquidity to the network. Therefore, interest rates will vary between nodes due to different security practices, captured here by the catch-all variable security risk premium.

r = time-value + security risk premium

Lightning Banks

Lightning Network will birth Lightning banks. Their first function will be to provide liquidity to Lightning Network by funding payment channels. They will try to position themselves as central routing hubs, capturing as many fees as possible. Competition will be open and fierce. Those with the greatest ability to efficiently manage payment channels and actively optimize routing positioning will profit.

Reference Rate

LIBOR was originally intended as an inter-dealer interest rate, however market conditions and manipulation scandals have significantly changed its role. Despite its evolution, LIBOR’s model could serve as an example for LNRR to follow. The calculation method for LIBOR is essentially a panel: banks are asked to submit rates and these rates are aggregated to form a reference rate published once a day. Lightning banks can publish their interest rates to each other in order to foster a dealer community similar to the LIBOR panel banks. Any node that can publish an interest rate can potentially contribute to LNRR, and ideally all interest rates that are published would be cryptographically provable by all participants to assure complete transparency.

Once Lightning banks establish LNRR, they can reference this rate and charge a spread for loans that are not secured by the Bitcoin blockchain. They can use the reference rate to attract deposits which would also not be secured by the blockchain. While off-chain, trusted, bitcoin denominated capital market activity does not benefit from Bitcoin’s immutability, it is essential for the establishment of bitcoin as a currency capable of global economic activity. Economic activity requires a tradeoff between time preferences which can only be achieved when savers are allowed to lend capital.

Conclusion

LNRR is not some magic solution. This paper is a suggestion to the Lightning developer community to start experimenting with the translation of HTLCs to a financial framework. We cannot go from Trace Mayer’s sixth network effect of financialization to the seventh network effect of reserve currency status without the correct financial tools. Bitcoin has already emerged as a new asset class and is now acting as a reserve asset for millions around the world. Transitioning from reserve asset to reserve currency will present a challenging path. Ideas like LNRR should be discussed and explored so that we can continue to push bitcoin forward as the world’s best abstraction of money.

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Sources

Bitcoin: A Peer-to-Peer Electronic Cash System by Satoshi Nakamoto

https://bitcoin.org/bitcoin.pdf

The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments by Joseph Poon and Thaddeus Dryja

https://lightning.network/lightning-network-paper.pdf

Mastering Bitcoin 2nd Edition — Programming the Open Blockchain by Andreas M. Antonopoulos

https://github.com/bitcoinbook/bitcoinbook

CRYPSA event with Trace Mayer

http://www.bitcoin.kn/2015/06/crypsa-event-with-trace-mayer/