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Allocation Problem
The LN was designed to decongest the blockchain and scale Bitcoin. The associated on-chain fees are reduced by taking transactions off-chain and processing them through a second layer. In short, the Lightning Network consists of Lightning Nodes with two-sided payment channels, and all the bitcoin are locked in these channels. The total amount of sat locked in a channel is called channel capacity. Inbound capacity limits the amount for receiving payments from a remote note, and outbound capacity limits the amount for sending payments by the local node. For the LN to function properly and to be usable, it needs to fulfill the following:
- Have enough Lightning Nodes connected
- Have enough payment channel capacity locked
However, establishing inbound capacity for Lightning Nodes is a known problem today. Inbound capacity refers to the ability of receiving payments to the extent of the remote balance. Having an insufficient remote balance available is a general issue for most Lightning Nodes. Today, it is difficult for users to fund payment channels in a cost-efficient way. The reasons for the shortage are the effort to obtain stable connectivity and the cost of providing liquidity.
Allocating bitcoin as working capital is a barrier for many Lightning Node operators. In addition, the volatility of bitcoin leads to significant currency risk. Only a few large participants are willing to bear the cost of holding substantial amounts of bitcoin in their Lightning Nodes.
This Working Paper assumes that professional participants in the LN offset currency risk by earning fees and generating return on investment through other means (e.g. add-on services like wallet providers and trading operations). Such an approach is generally not available to retail users of the LN. Due to the lack of risk mitigation tools, small Lightning Nodes carry increased economic risk when processing micro-payments on a P2P basis.
The need to allocate funds to tie up liquidity in payment channels without sufficient incentive is an obstacle for professional and retail users alike. For instance, crypto exchanges are constantly looking for ways to limit their exposure. The capital requirements prevent exchanges from participating in the LN because the incentives paid by Lightning Nodes alone are not an attractive value proposition compared to leveraging bitcoin by other means (e.g. operating margin trading facilities).
These capital requirements represent a critical resource allocation problem.
