DIGITAL ASSETS ON THE MOVE
A Possible Cause of April’s Rally
The crypto market experienced a large spike on April 2, initiated by bitcoin’s sudden price increase by approximately 20% against the USD. This simultaneously pulled the rest of the market upwards, increasing trading activity and general positive sentiment. According to some sources, the bitcoin price increased after a large market order from a single buyer across Bitstamp, Kraken, and Coinbase at the same time, amounting to about 20k BTC all together.
Bitstamp BTCUSD, daily chart. Source: TradingView
The sudden price increase of bitcoin had two effects on other crypto assets. The first is technical, as the majority of altcoins and tokens have a large share of trading volume denominated in BTC. This means that they will generally move in the same direction as BTC (in USD value), especially when looking at BTC’s shorter timeframes.
The second effect is behavioral, as many crypto traders and investors are currently anticipating a market reversal, the end of the crypto winter. A combination of great overall progress and advancements in the industry–such as DeFi, PoS, and governance–and the sudden price increase of bitcoin have certainly given out an important positive signal. The sudden price increase also caused a short squeeze in several markets. A short squeeze occurs when a sudden price increase liquidates a large number of short positions. Short positions are liquidated by buying back the leveraged asset with a market order, which, depending on the depth of the market, can also force other short positions to be liquidated. An example of a short squeeze in the Bitfinex BTCUSD market can be seen in the chart below. Short open interest declined drastically due to short positions being liquidated.
Bitfinex BTCUSD short open interest, hourly chart. Source: TradingView
What do High L1 Fees Mean for Lightning Network?
Lightning Network (LN) is a network of payment or state channels, a second-layer technology, that is being developed and implemented on several different blockchain networks, the largest currently being Bitcoin. The basic idea of a state channel is that two parties open a channel off-chain and can make transactions between each other by updating the state of the channel instead of paying transaction fees on-chain for every single transaction. The net outcome of the channel is later settled on-chain by both parties signing the final state of the channel. When Alice has an open channel with Bob and Bob has an open channel with Christine, Alice and Christine can also transact with each other—this is the Lightning Network. Of course, the system is a bit more complicated, but this is essentially how it works.
While there are several approaches to increase the capacity of a blockchain network, Bitcoin chose LN as its main approach, and as it turns out, custodial solutions are required in order for LN to function as intended, while L1 network is experiencing high transaction fees. Transacting in LN requires at least two on-chain transactions: one for opening a channel and one for closing it. For example, suppose an individual opens a channel with a large hub (someone who has many open channels with different parties) with $50 worth of bitcoin. He pays $2 for the transaction to open a channel and is left with the rest, which he can then spend inside the LN. Meanwhile, bitcoin increases in price, which leads to greater general interest in Bitcoin, increased on-chain activity, and, therefore, higher network fees. Now the network fee is $50 (the actual average Bitcoin transaction fee on 12/22/2017) and our individual is left in limbo, as his funds are unspendable.
Funds in a state channel always have a reservation for a network fee, which is required to close the channel, meaning that each state channel needs to be sufficiently funded, as L1 fees will probably increase dramatically if the block size remains restricted to 1MB. The solution to this problem is custodial services, which are already emerging in the form of wallet providers. A wallet provider has many channels open with larger hubs and other similar services, and their channels are well funded and provide sufficient capacity for regular transacting. A custodian takes users’ deposits on-chain and lends them funds on LN so they can make cheap transactions. The only problem with this solution is that it does not solve the first problem, the problem Bitcoin was trying to solve in the first place: having a trustless network for value and information exchange in which participants are not dependent on trusted third parties (banks). LN on its own does not solve the scalability issue of Bitcoin in a trustless way if L1 transaction output does not increase.
In the case of stale L1 capacity, there is another problem to tackle that is yet to emerge. Currently, Bitcoin is in the third reward era. Block rewards are halved approximately every four years. Rewards started with 50 bitcoin per block in 2009, and currently, each block reward yields 12.5 bitcoin. When the protocol issues a small amount of bitcoin per block, the only compensation miners will receive for securing the network is transaction fees. The network will need to host a large number of transactions for miners to keep using their computation power to secure Bitcoin, meaning L1 capacity has to be increased or limited supply has to be changed.