Economics

Bitcoin L2

Plenny’s token economy calculations are based on Lightning Network fundamentals. The LN is a second-layer technology using micro-payment channels (i.e. P2P state channels) to scale the Bitcoin blockchain. Off-chain capabilities are used to offer an instant-payment experience. Transactions conducted over lightning are faster and less costly compared to those conducted directly on the bitcoin blockchain (i.e. on-chain).

In principle, the Lightning Network is supposed to solve the scalability problem. Lightning payments do not use proof-of-work consensus, require no mining, and have no 10-minute confirmation time, thus enabling instant transactions at the speed of light. The difference between the Bitcoin and Lightning protocol is that Bitcoin broadcasts each transaction to the chain, whereas Lightning verifies a channel status against the chain.

It is a network of Lightning Nodes and payment channels, which means every node with channels is connected to at least another node. When two counterparties decide to open a channel on the LN, they need to fund the channel through a transaction on the Bitcoin blockchain. In the opening transaction, each node commits an amount of bitcoin recorded on-chain that funds their side of the channel.

For example, Haley and Adam each commit one bitcoin to their side of the channel in the opening transaction. They do this by both signing a multi-signature UTXO (Unspent Transaction Output). In simplistic terms, they have now locked up one bitcoin each that can only be moved by a new input from the channel on the LN.

The above is an example of a bi-directional channel, which is limited to two transacting parties. However, the payment network is not only built on bidirectional payment channels. Instead of establishing a direct payment channel to every other party participating in the network, a technique called Hash TimeLocked Contracts (HTLCs) allows payments to be routed to other Lightning Nodes and sent through a path of payment channels on a non-custodial basis.

The P2P architecture makes lightning transactions structurally more centralized than on-chain bitcoin transactions. Well-connected nodes (or hubs) are an essential part of the LN. Thus, while clustered nodes in some sense lead to increased centralization of the LN, the network itself is not inherently centralized, it’s merely a property of the network users may opt to take advantage of.

Practically, the LN offers almost free, instantaneous, and private (off-chain) payments. Users always have the option to open their own channels, both private and public.

In 2021, researchers observed a declining clustering coefficient, indicating peers on the LN make increasingly more rational decisions when opening new channels. In general, payment channels tend to be opened with nodes that are connected to a minor group of nodes, “which the Lightning Node has not opened a channel with.” The opening of this channel gives the node a route to this subgroup of nodes and “the ability to route transactions to these payment channels.” Given these nodes also tend to be connected to another subset of nodes, the node gains the ability to route a transaction more efficiently on the broader network (Arcane Research Report, 2021).

Moreover, the LN is chain-agnostic and works on any blockchain that uses the same algorithm for the hash lock (e.g. Litecoin), but Bitcoin is its main protocol. While SegWit made on-chain transactions cheaper in 2017 by solving transaction malleability and bringing the LN to life, Taproot makes them indistinguishable from normal transactions to the Bitcoin protocol and Lightning Network. The Taproot Soft Fork upgrade adds another layer of privacy for participants and was activated in November 2021.

Using Taproot technology, Bitcoin can host massive smart contracts with tens of thousands of signatories but retains the size of a single signature transaction. Moreover, some contend that Taproot, combined with Lightning Network, will advance BTC’s utility from primarily a “store of value” to an efficient “medium of exchange” by upgrading the network’s core cryptography to ensure network security. Taproot is assumed to inspire more developers to work on Bitcoin by enabling complex DeFi smart contracts.

Diving into the details, key aggregation allows Bitcoin to compete with higher throughput blockchains such as Ethereum, which is the primary breeding ground for DeFi Projects. By the end of 2021, more than 40 hardware wallets, software wallets, web wallets, and exchanges have adopted Taproot for deposits or withdrawals (i.e. adopting the corresponding bitcoin address format, meaning Bech32 and Bech32m).