Lightning Network May Not Solve Bitcoin’s Scaling ‘Trilemma’

Bitcoin has proven incapable of accommodating growing demand without deviating considerably from Satoshi Nakamoto’s original vision of a “peer-to-peer electronic cash system.”

It was intended to provide a fast, secure and inexpensive means of making payments without using the traditional financial system. Today it still only manages a tiny proportion of the traffic of, say, Visa or Mastercard, yet has become cripplingly slow and very expensive.

Solving bitcoin’s scaling problem has become a principal concern of developers. But the problem has proved intractable.

Now, making a virtue out of necessity, the buzz is that bitcoin is “digital gold.” Its built-in limit of 21 million bitcoins makes it an ideal anchor for a hard-money financial system similar to a strict gold standard. A new payment system could be built on top of it.

The problem is, it isn’t possible to have full decentralization, a fixed money supply and sufficient liquidity for an efficient payments system. This is bitcoin’s “trilemma.”

Immobile money

In the gold standards of old, there was no trilemma. They were always centralized.

For example, the “classical” gold standard of the 19th century was the heyday of the British Empire, which at that time covered a third of the globe. The pound was the currency of international trade, and it was backed by gold.

Countries in the empire were forced on to the gold standard by the British government; countries outside the empire joined the gold standard, or even adopted the pound as their currency, because it made trade much easier.

In the center of the web, the Bank of England managed both the price of gold and pound issuance. It was the most centralized financial system since the Roman Empire.

But for bitcoin, the fact that it is designed as a decentralized system means something else has to give. And the clue is its rapidly rising price.

Bitcoin is becoming illiquid.

Bitcoin’s growing illiquidity is due to a toxic combination of high demand, hoarding and designed-in scarcity. The rapid price rise indicates that purchases have increased much more than sales. More and more people are buying bitcoin in the hopes of cashing in as the price rises, while those who already own bitcoins are Holding On for Dear Life for the same reason.

People are also reluctant to spend their bitcoins, because that rapidly rising price means that they face huge opportunity costs.

And although bitcoins are still being mined, the rate at which they are mined is nowhere near enough to meet demand – and anyway, miners too can HODL their bitcoins.

Meanwhile, rising transaction volumes are causing network congestion. Bitcoin has no means of adjusting capacity other than rationing verification. Miners verify transactions with higher fees more quickly than those with lower fees. Those who want fast verification (which is nearly everyone, since bitcoin’s price is rising so fast) will pay higher fees. Those who don’t want to pay higher fees must wait longer for their transactions to settle.

Bitcoin’s popularity therefore means both higher transaction fees and slower settlement times. The design feature intended to prevent it coming to a hyperinflationary end is driving it towards deflationary gridlock. As Business Insider asked, what on earth is the point of money that you can’t spend and can’t convert to anything else?

But is there a way round this problem? The clever folks working on the Lightning Network think so. Their solution is to take most transactions off-chain, and to share liquidity across the network…

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