The Lightning network is often touted as a second layer built on top of Bitcoin to help make bitcoin payments, fast, cheap, and scalable. While that’s completely true, I’d like to propose that the lighting network is actually an entirely new layer of incentives that is far more valuable than just fast cheap payments. Understanding the game theory of the lightning network will help you realize that it’s about a lot more than just scaling.
How Does Lightning Network Work?
Once you fall so far down the bitcoin rabbit hole, you’ll hear about the Lightning Network (I will refer to it as lightning or LN for the remainder of this article). The LN is a second layer that enables cheap payments that settle within seconds rather than waiting for the next block which takes an average of 10 minutes.
– Lightning makes payments incredibly cheap so more people can use bitcoin to make small purchases like a cup of coffee and not be crippled by on-chain fees that cost more than the cup of coffee.
– It makes bitcoin payments so fast that you can actually buy a cup of coffee while you’re standing at the counter placing your order. No need to wait for on-chain confirmations.
– It makes bitcoin a viable payment network that is capable of processing more transactions per second than legacy payment networks like VISA, MasterCard, and PayPal.
Lightning makes bitcoin more than just a digital gold settlement layer. It makes bitcoin usable for everyday transactions.
These are all nice benefits of using the lightning network but I would like to add my two sats on why the LN is actually a whole new layer of game theory & incentives that makes Bitcoin even more powerful than it already is.
Game Theory Of On-Chain Payments VS. Lightning Payments
To understand how the lightning network works, it helps to have a basic understanding of how the game theory of on-chain payments work vs. how they work on the lightning network. On-chain fees are decided by those sending transactions while on the LN, the fees are decided by the Bitcoin lightning nodes that route payments.
Let’s look at each one in more detail.
On-Chain Payments: Bidding UP The Price By Senders
When you send an on-chain payment, you send bitcoin from one address to another and attach a miner fee to incentivize the miners to include it in a block. The higher the miner fee, the greater the incentive for miners to include it because they get whatever fee you attach to your payment.
The fees to send bitcoin on-chain are essentially bids between everyone who wants to send an on-chain transaction and the mempool is the fee market where senders place their bids. On-chain payments employ a winner-take-all game theory. Whichever miner or mining pool finds the next block wins the block reward and gets to select which transactions they will add to the blockchain.
Only the miner(s) that finds the next block wins the block reward. There is no second place. This game theory of bitcoin mining is a very important aspect of bitcoin because this competition is a large part of what keeps bitcoin so secure.
In short, on-chain fees are decided by the senders of the transactions. The higher the demand for limited block space, the higher the fees. There’s not much of an economic incentive for on-chain fees to decrease. It’s that simple.
Sending bitcoin on the lighting network works a bit differently which causes some very different game theory to play out.
Lightning Payments: Bidding DOWN The Price By Routing Nodes
When you send on the lightning network, the fees aren’t decided by the senders competing for limited block space.
On the Lightning Network, the fees are decided by the nodes that route lightning payments.
This dynamic causes senders to naturally gravitate towards the cheapest route to send a payment to their destination.
This is an incredibly important characteristic to understand about the lightning network because the competition between lightning nodes is an incentive to lower the cost of sending payments while no such incentive structure exists on-chain.
Bid Up vs. Bid Down
To sum things up, sending bitcoin on-chain causes a bidding war to outbid other senders with a higher fee in order get added to a block first. Lightning payments cause a bidding war between the routing nodes to bid lower than the other routing nodes in order to route more payments and potentially earn more bitcoin from routing fees.
This simple dynamic is already playing an important role in how Bitcoin is scaling because it provides a much needed economic incentive for lower on-chain fees. It doesn’t stop there though. The lightning rabbit hole has a lot of twists and turns.
Opening Lightning Payment Channels
The LN is a complex network of payment channels that are run by lightning node operators. Opening a payment channel requires an on-chain transaction which will need to compete with all of the other pending on-chain transactions in the MemPool. If you want your payment channel opened as soon as possible, then a high miner fee is probably the best option. If you don’t mind waiting a while, you can use a lower fee and your channel will be opened as soon as your transaction fee is confirmed on-chain.
High Fee. Low Wait Time.
In order to get a payment channel opened as quickly as possible, you can simply initiate a transaction with a high fee and be included in a block shortly thereafter. This has the benefit of being added to the blockchain as soon as possible so you can begin processing lightning payments in the least amount of time. The downside of this for node operators is that it will take longer for your node to recoup the cost of your high fee.
Low Fee. High Wait Time.
If you are not in a hurry to open a payment channel, you can open one with a smaller on-chain fee. It will take longer to be added to the blockchain but if you plan on routing lightning payments, keeping your overhead as low as possible might be a good strategy.
Batched Transactions To Open Multiple Channels
If you would like to save on miner fees as well as open multiple channels at the same time, using a batched transaction to open multiple channels at the same time is a great way to save on fees while also opening multiple channels at once. Again, if you are planning on routing lightning payments, this could be a very valuable strategy to keep your costs low while also increasing your connectivity to the rest of the lightning network.
Opening channels with high fees, low fees, or multiple channels at the same time will all affect how soon a lightning node becomes profitable and thus a net positive for the Bitcoin network as a whole.
Routing Lightning Payments
If you would like to attempt to earn some bitcoin from routing lightning payments, you need to run your own Bitcoin node and stay competitive against other lightning routing nodes. There are 3 main ways that you will need to compete with other nodes. Depending on your own personal situation and strategy, you might be able to compete using one or all of these.
– Liquidity
– Connectivity
– Fees.
Let’s look at each one in a bit of detail.
Liquidity
This is probably the most important part of being able to transact on the LN. If you don’t have any bitcoin on the lightning network, you simply cannot route any payments. It’s that simple.
In order for you to be able to route any payments, you are going to need some sats in at least 2 payment channels and that requires an on-chain payment to open each channel. Why 2 payment channels? Because your node needs to be in-between at least 2 other nodes that may be sending transactions and your node operates as a route between them.
In order for a node to route any payments, there needs to be liquidity in each and every channel. The more liquidity that you have in your payment channels, the greater the probability that you will route payments but that’s an overly simplistic explanation.
Allow me to go into a bit more detail…
The More You HODL On LN, The More You Can Earn
This is where it pays to have more bitcoin in your payment channels than other routing nodes. Typically, in order for your LN node to be able to route a payment, you need to have at least as much Bitcoin as the payment being routed. For example, if someone wants to send .01 BTC on the LN, you need at least .01 BTC in a payment channel in order to be able to route that payment.
It’s possible that the amount of liquidity held by any single channel will become less relevant because something called multi-path payments (MPP) has been adopted by a number of routing nodes. MPP allows for payments to be split into smaller payments and routed to the destination via multiple nodes instead of just one.
MPP is good for keeping the lightning network reliable because it allows for nodes with less liquidity to potentially earn more bitcoin while also enabling senders to send larger transactions on the LN. These are good for both the users of the LN as well as the routing nodes.
It’s possible that having more liquidity than other channels may become less relevant as MPP becomes more widespread. Until MPP is implemented by every routing node, it pays to have more liquidity than other channels.
Balanced Channels
Not only does the amount of liquidity that you have play an important role with how competitive you are but how well balanced or how “well managed” your payment channels are is also plays an important role in your node’s profitability. Part of what ensures that the LN can reliably send payments is that all of the channels have enough liquidity for a transaction to go both ways.
Keeping a node’s liquidity balanced it an important part of understanding the game theory of the lightning network.
Lightning Pool
If all of this game theory, competition, and technical jargon is too much for your to grasp right now, don’t worry. There are tools being developed to make it easy so that you can simply lease payment channels from LN node operators so that you don’t have to worry about all of this technical noise. The Lightning Pool is one such tool for growing the lightning network.
Well balanced liquidity is important but in order for the lightning network to be an actual network, nodes need to be connected to other nodes. This connectivity is also an important part of routing the largest amount of payments possible.
Node Connectivity
I know this is a bit of a cop out but I am going to reference Metcalfe’s Law real quick to highlight that the value of a network is relative to the number of users within that network. The lightning network is no exception.
You can have a lot of bitcoin on the LN but if your node is not connected to other nodes, then you won’t route any substantial amount of payments. You need to be connected to other nodes. This is where you need to compete with other nodes to be more connected than they are.
More Channels. More Value.
In order for your own lightning node to maximize the number of payments you can route, the number of other nodes that you are connected to has a direct impact on the number of payments that you can potentially route.
For example, you are likely to route more payments if you node is connected to 50 other nodes rather than just 5. It gets even more in-depth than just that though. It’s not just about the number of connections you have all by itself. The connectivity of the nodes that you connect to is also important.
More Connected Channels. Even More Value
If you want to open up the potential opportunity for your own network to other networks of peers, it helps to have peers with peers.
Connecting to other nodes that are well connected can open you up to the potential to route more payments but sometimes connecting to less connected parts of the LN may be a better strategy because you are increasing the total size and value of the network.
Connecting To Unconnected Parts Of The Network
If you are trying to maximize the value that you add to the LN, connecting your own network of payment channels to other networks of channels can be a good place to start. Often times creating connectivity where there currently isn’t any can be one of the best ways to get more payments routing through your node.
Since not every single node is connected to the larger network of LN nodes, there are a number of smaller “mini lightning networks”. Sometimes being the bridge that joins these smaller networks to the greater network can be a good strategy because you are helping to join both networks and this increasing the value of the overall network.
Now, let’s discuss how you can actually earn bitcoin with the lightning network. Naturally, I am talking about fees.
Routing Fees
Last but certainly not least, every node within the LN competes on the cost of routing payments. The lower the fees, the more likely you are to route payments. While that may seem pretty simple at first, it can actually get pretty complicated when you realize that you are also competing with everything else I’ve mentioned so far.
Zero-Fee Routing
Some lightning nodes have decided to route payments with zero fees because they are attempting to find other ways to generate revenue with their node. When a node charges 0 sats to route a payment, it makes sense that a lot of other nodes would connect to it because payments cannot get any cheaper than completely free. Instead of generating revenue from charging routing fees, these 0 fee routing nodes are usually leasing payment channels to companies for a price.
While it’s too early to tell if this business model is viable long term, it has absolutely enabled incredibly cheap LN payments.
Low Routing Fees
Routing fees as low as 1 satoshi also seem to be popular for now but as the network grows, it’s possible that existing node operators will learn that it actually costs a lot more than 1 satoshi to route a payment. Just the electricity to run a node might cost more than 1 sat for every payment routed.
While these low fee node operators are acting voluntarily, it may just be a matter of time before they end up driving themselves out of business as everyone routes payments through them and their payment channels get exhausted and constantly needs to be rebalanced.
What may prove to be a more sustainable strategy is starting with higher routing fees and then slowly bidding down the price until an actual market price for routing payments gets discovered.
High Routing Fees
Some routing nodes will naturally choose to charge higher fees depending on how they are competing on all of the other points mentioned.
If you have lots of liquidity, lots of open & balanced payment channels, and are well connected to other nodes, you may be able to charge higher fees since you are providing more value than other channels/nodes. As other routing nodes begin to offer lower routing fees than you, it may mean that you need to increase the size of your channels, lower your fees, or open new channels in order to stay competitive.
Once your node has routed enough fees to justify the cost of the opening transaction and your operating costs, you may decide that it’s time to “take some profit” and close out some channels.
Closing Payment Channels
Just when you thought the LN game theory rabbit hole couldn’t go any deeper, here’s even more ways that node operators both cooperate and potentially compete with each other. Once a channel has been opened and any number of payments have been routed, one of the channel owners may want to close out the channel. This requires an on-chain payment but there’s a catch when it comes to closing a channel.
One of the channel owners can attempt to cheat the other and steal their bitcoin.
To prevent this from happening, an arbitration agreement is used in the payment channel smart contract. Either party who co-owns the payment channel can cooperatively close the payment channel or one party can attempt to unilaterally close the channel.
Cooperative Close Vs. Force Close
There are two ways to close a payment channel: Cooperatively or Non-Cooperatively.
If both Alice’s & Bob’s nodes are online, then they can decide to cooperatively close out a payment channel. They would come to an agreement on channel closure fees proposed by either party and the channel would be closed. Funds would be sent back to their respective wallets and that would be the end of that particular channel. This is the most common way that payment channels are closed on the LN but both nodes are not always online or maybe either Alice or Bob is unwilling to sign the closure transaction.
Additionally, if on-chain fees are high, either party might not want to close out the channel due to high closure costs. This keeps the channel open and routing more payments. If the cost of on-chain fees is low, then closing out the channel is more cost effective.
In the event that either one of the lightning nodes is not online or unwilling to sign the closure transaction, the owner of the online node is still able to close the channel in a non-cooperative way. In the event that one party attempts to cheat the payment channel smart contract, the counter-party is able dispute the fraudulent closure transaction by broadcasting an honest version of the closure transaction and the bad actor forfeits their portion of the payment channel.
Here comes another bend in the LN rabbit hole. There’s also the chance that whoever is closing the payment channel is actually sending the balance to open another channel or even multiple channels.
Closing A Channel To Open Others
Closing a payment channel is where a payment channel seemingly comes to an end but the reality is that when you close out a payment channel (or multiple channels), that on-chain transaction can actually be the same transaction that opens up another payment channel (or multiple new channels).
This has immense implications for routing nodes who are interested in keeping their costs as low as possible while also keeping their channels open and balanced. Using this method also helps to keep on-chain fees low by helping to keep the MemPool as clear as possible.
The Lightning Network Is All About Game Theory
When I first heard about the lightning network, I just thought that it was a way to make payments faster and cheaper but the reality is far more substantial than that.
It is an entirely new network that runs on top of the bitcoin network that competes with the existing on-chain fee structure and offers an entirely new incentive model.
To operate a routing node on the LN, you need to consider the cost of on-chain fees when opening channels, how much liquidity you have in each channel, how balanced your channels are, how well connected your channels are, the fees that you charge to route through your channels, who closes the channel, the cost of on-chain fees when you close channels, and whether or not your closing channel transaction will open new channels.
That’s a whole lot of game theory that you probably have never thought about until now.
There’s game theory at almost every level of the lightning network and as the price of bitcoin continues to rise, understanding how all of the points I mentioned above may prove to be useful for anyone who wants to stack sats by operating an LN node.
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