Lightning Networks on Blockchain, Legal and Regulatory Perspectives
In our recent paper, “LApps: Technological, Legal and Market Potentials of Blockchain Lightning Network Applications” presented at a conference and published at the ACM Digital Library, David Donald and I investigated the current states of development of Blockchain Lightning Network (LN) along with its possible non-monetary usage, especially in settlement coloured coins such as securities, as well as creation of new business models based on Lightning Applications (LApps) and microchannel payments as well as micro-trades. The legal challenges that may act as impediment to the adoption of LN is also discussed.
Following in the footsteps of pioneer Bitcoin, many altcoins as well as coloured coins have been being developed and merchandised adopting blockchain as the core enabling technology. However, since interoperability and scalability, due to high and capped (in particular cases) transaction latency are deep-rooted in the architecture of blockchain technology, they are by default inherited in any blockchain based applications. Lightning Network (LN) is one of the supporting technologies developed to eliminate this impediment of blockchain technology by facilitating instantaneous transfers of cryptos.
What is a Lightning Network?
A Lightning Network (LN) is a second layer Hashed Timelock Contract (HTLC) based smart contract enabling bi-directional payment channels built on top of a base layer of blockchain such as Bitcoin. LN effectuates secure routing of payments or transactions of coloured coins across multiple peer-to-peer (P2P) payment channels enabling transactions between two parties who are not directly connected by any point-to-point channel. Thus, by off-loading the transactions away from the base layer, LN engineers instantaneous transfers of assets, cryptocurrencies or other crypto assets with near-zero transaction fees. The concept of lightning network was first revealed in December 2015 by Joseph Poon and Thaddeus Dryja, however, it took almost two years to undertake a series of successful implementations of interoperable test transactions on Bitcoin core network in December 2017.
So far, there have been several variant implementations of the originally proposed LN, following recommendations from other developers of the Bitcoin community. The three major implementations are: Blockstream’s “c-lightning” implementation in C, Lightning Labs’ Golang’s implementation of “Lightning Network Daemon (LND)” and ACINQ’s Scala implementation of “eclair”. A complete updated list can be found at GitHub. All three of these have been proven interoperable by real LN transfers. Ethereum’s Raiden Network is also an example of off-chain scaling similar to LN.
Major Advantages of LN
Since LN is the enabler of off-chain atomic cross-chain swaps, all the benefits atomic swap can offer are imputed to LN including those of sidechains.
Off-chain scaling such as LN will help cryptocurrencies to compete with fiat currencies to some extent.
Off-loading some transactions away from the base layer of chain will shorten the processing queue of “unconfirmed” transactions which will result in reduced on-chain transaction fees.
Improved privacy is another key advantage of LN as the transactions are not recorded on the base DLT. Onion style nested routing approach adds an extra layer of privacy as the intermediate hops can only see the next hop’s address, without revealing the final destination address.
Merchants of commodities such as online shops or food outlets can open a LN Channel and receive instant payments.
Since the transaction fee is near-zero, LN effectively works as a micropayment channel.
LN based LApps possess great potentials to lead the creation of new ventures and innovative business models.
LN actuate micro-trading of cryptocurrencies and other crypto assets.
LN has the potentials of being used in the settlement of non-monetary coloured coins such as securities.
Lightning Networks from a Legal and Regulatory Perspective
Since nodes in the LN act as a money transmitter, there is a debate whether registration as a money transfer is a legal requirement. However, the laws related to money transmission differ across various countries, even sometimes among states of a country, such as in the US. Laws of many countries or states even lack clarity on whether the law for fiat currencies can be applied to cryptos. In fact, the nodes of LN do not acquire real ownership of the funds while being transmitted. Therefore, they cannot possibly nobble. Effectiveness of applying money transfer law in this case thus may not justify its intention to protect consumers.
For legal certainty, the current governance approach of standard framework agreements applied in international swap transactions can also be used for atomic swaps, with very little adjustment necessary once the framework is set in place.
From a regulatory viewpoint, swaps and/or transfers present the problem that they could traverse geographic boundaries of political entities or legal jurisdictions. Such transnational activity is harder to regulate and monitor by the regulatory bodies or similar government agencies of any jurisdiction. Secrecy is added to this regulatory difficulty. Due to the implantation of an onion style routing approach, even if LN channels created by other users are used to facilitate a transaction or swap, and only the final netted balance is broadcasted to the base blockchain network for consensus, the intermediate transfers or swaps remain private. No one but the transacting parties knows the actual transaction details. This feature of LN can contribute to the rise of illicit markets.
As the LN technology has existed in operable form for just around one year and is still being used in restricted manner, we consider this still to be a research and development (R&D) phase. However, as LN technology matures, its more concrete utilisation of the technology in various applications is expected, especially for transfer and fungibility of digital assets.
Mahdi H. Miraz, The Chinese University of Hong Kong