Lightning
Nov 21, 2023

Centralization in the Lightning Network: Are We Trading Away Bitcoin's Core Values?

Today custodial wallets play a crucial role in the lightning ecosystem

Centralization in the Lightning Network: Are We Trading Away Bitcoin's Core Values?

The Lightning Network, a layer-2 payment protocol built on the Bitcoin blockchain, enables faster, more scalable, and cost-effective transactions by facilitating off-chain transactions between multiple parties. The network's appeal lies not only in its scaling capabilities but also in its commitment to upholding and enhancing Bitcoin's core values.

As the Lightning Network develops, the demand for low-fee microtransactions is increasing. The decentralized social network Nostr has seen a surge in microtransactions across its platform, taking place via zaps, which are payments made to lightning addresses connected to users' profiles.

While anyone can create their own lightning address on their lightning node, Zapalytics data shows that 91% of zaps are conducted using custodial wallets, and 94% of lightning addresses are associated with these wallets.

Nostr Users Choose Custodial Wallets

Custodial lightning wallets are managed by third-party service providers responsible for holding users' private keys and funds, while non-custodial lightning wallets give users full control over their private keys and funds.

Today, custodial wallets play a crucial role in the lightning ecosystem, but is this centralization cause for concern?

Main risks of centralized custodians include:

Loss of funds due to theft: Users trusting third-party providers to securely manage their funds risk losing them through malicious intent or negligence.

Fractional reserve practices: Large amounts of bitcoin in custodial wallets could lead to fractional reserve practices, putting users' funds at risk and jeopardizing Bitcoin's 21 million supply cap.

Threat to censorship resistance: Centralized entities facilitating most transactions may be vulnerable to coercion or regulation by governments or powerful organizations, undermining the network's censorship resistance.

Impact of failure: Today, Zaps on Nostr and LN users in general heavily rely on Wallet of Satoshi, if they have a problem it affects the overall network.

Short-term centralization in the Lightning Network may be worth it

Despite the concerns about centralization, some arguments suggest that it's beneficial for Bitcoin in the short run and unlikely to persist in the long run:

Convenience and ease of use: Custodial wallets offer a more straightforward experience, driving Lightning Network adoption.

Increased efficiency: Professional node management by large custodial providers reduces the likelihood of payment failures.

Market-driven solutions: Market concentration of service providers may diminish over time as more competitors enter the market. If users perceive significant risks with a specific wallet, they may migrate to other services or non-custodial wallets.

Discussion

Centralization in the Lightning Network may be a risk worth taking, as long as the main Bitcoin blockchain remains decentralized. However, this perspective clashes with Bitcoin's culture of deliberate progress, which has consistently prioritized decentralization and the preservation of its core values over rapid adoption or short-term gains.

In the past, the Bitcoin community could have accelerated mass adoption by increasing its block size, but node users consciously chose to prioritize foundational values over expediency. This decision has proven its merit over time, highlighting the significance of adhering to Bitcoin's guiding principles.

Should we never make trade-offs in pursuit of adoption? Generally, the answer may be yes when it comes to the base layer. However, we are now dealing with a higher layer in the Lightning Network, and that distinction matters.

Ultimately, the market will determine what is important. Users can decide if the personal risk of a custodial wallet outweighs the benefits. Personally, I use a custodial wallet provider for my Lightning Network transactions and feel comfortable with the risk, given the relatively small amount of value involved.

Nonetheless, I recognize that users acting in their own best interest can sometimes lead to suboptimal outcomes. If everyone uses custodial wallets, this could pave the way for fractional reserve banking on the Lightning Network. The severity of this issue may depend on how much bitcoin ultimately needs to reside on the Lightning Network. If a minuscule percentage of bitcoin sits on the network due to its high velocity, then the problem may be less significant. However, as outlined here, a possible scenario is that ~20% of the overall Bitcoin network may need to sit on the Lightning Network for it to scale. In this case, the potential for fractional reserves becomes much more concerning.

As the Lightning Network continues to evolve and mature, it is crucial to find a balance between embracing centralization for convenience and upholding the core values of decentralization and censorship resistance. While I may not have all the answers, I believe it is essential for the community to ponder these issues and make trade-offs intentionally.