Lightning, the scaling solution for Bitcoin, promised fast and cheap transactions with a few trade-offs. Instead of providing the same UI as on-chain transactions, Lightning offers an entirely new ecosystem filled with its own technical competencies and learning curve. The many hurdles, like remaining online, managing liquidity and channel sizes, and more, have limited the adoption of Lightning in a self-sovereign manner.
As a stop-gap solution, a few Lightning apps offered users the ability to manage a Lightning wallet with a custodian or Lightning Service Provider managing the infrastructure and funds. The ease of use naturally attracted a large following as these wallets made it so easy to conduct micro-payments and interact with the growing number of Lightning and Bitcoin-enabled websites and applications.
These apps have become so ubiquitous in the Lightning market that in most cases when Lightning is advertised or demonstrated by users on social media to purchase that coffee or cheeseburger at McDonald’s, it’s done by users of custodial Lightning apps.
Custodial Lightning has always been a temporary solution while the protocol matures, but it looks like Lightning will need to grow up fast as a curious trend has emerged: custodial Lightning wallets are capping the amount of funds users can hold. This move has left many scratching their heads, wondering why these wallets, meant to simplify the Lightning experience, suddenly impose limitations.
So what’s going on? Wouldn’t it be advantageous for LSPs to host more channels or bigger channels and make more fees from users? Why would they knee-cap their earning potential?
Let’s delve into the possible reasons behind this decision:
Popular custodial Lighting wallets are pumping the breaks
| Lightning Wallet | Balance Cap |
|---|---|
| Alby Wallet (Custodial Version) | 1 000 000 Sats |
| Blink Wallet | TBC |
| Zebedee (Without KYC/ With KYC) | 500 000 Sats / 5 000 000 Sats |
| Wallet of Satoshi | 500 000 000 Sats (5 BTC) |
1. Regulatory compliance
As Bitcoin becomes larger and clears more transaction volume each year, it limits oversight from governments and institutions as individuals can get around many of the restrictions and incompetencies of the current banking system.
Governments and regulatory bodies are actively seeking ways to crack down on the flow of Bitcoin, locally and internationally, and single companies are the easiest target.
Depending on their jurisdiction, custodial wallets might face Anti-Money Laundering (AML) and Know-Your-Customer (KYC) regulations. Capping individual balances could be a way to comply with these regulations and mitigate the risk of facilitating illegal activity.
Regional bans on Lighting wallets have also begun to take shape. Due to regulatory restrictions, custodial Lightning wallets might not operate in countries like:
- Azerbaijan
- Belarus
- Cuba
- Dominican Republic
- Iran
- Iraq
- Russia
- Syria
- Sri Lanka
- Uzbekistan
- United States
- North Korea
Uncertain Regulatory Landscape
The regulatory environment surrounding Bitcoin and Lightning Network in the USA remains unclear. While not explicitly regulated yet, potential future regulations around KYC/AML compliance, taxation, and anti-money laundering (AML) measures could pose challenges for these wallets. By limiting users and funds, wallets potentially mitigate risk in an uncertain legal climate.
Financial Action Task Force (FATF) Travel Rule
The FATF’s Travel Rule, which aims to track the origin and destination of virtual asset transfers exceeding $1,000, poses compliance challenges for Lightning Network, known for its fast and often private transactions. Wallets are likely implementing restrictions to comply with potential future implementation of the Travel Rule in the USA and beyond, especially with protocols like UMA laying the foundation.
Concerns about Illegal Activity
Lightning Network’s speed and relative anonymity have attracted criticism for potentially facilitating illegal activities like financial crime and tax evasion. Wallets, mindful of reputational risks, might use limited access and fund caps to distance themselves from potential association with such activities.
It’s important to note that the situation is still evolving, and regulations surrounding Bitcoin and Lightning Network in the USA are yet to be finalised. It’s likely that wallet restrictions will continue to adapt as the legal and technological landscape around Bitcoin and Lightning Network changes.
2. Risk management
Custodial wallets hold your private keys on their servers, making them responsible for securing your funds. By limiting the amount per user, these wallets manage their risk exposure. A large hack with all funds concentrated in one place could financially devastate the provider.
3. Liquidity management
Lightning transactions occur off-chain, meaning funds aren’t readily available on the main Bitcoin blockchain. Capping user balances ensures the wallet provider has enough liquidity to facilitate withdrawals, and the channel opens/closes efficiently.
4. Target Audience and safety
Some custodial wallets might cater to users with smaller amounts of Bitcoin, making high limits unnecessary. Limiting balances can also encourage users to take ownership of their funds instead by exploring non-custodial Lightning options or moving funds on-chain that would otherwise have sat dormant and at risk with an LSP.
5. Gradual trust building
As a financial app, you live and die by your UI and security. Some wallets might be cautiously building trust with their users by starting with lower limits and gradually increasing them. This approach allows them to test their security measures and infrastructure before scaling up.
As LSPs and app developers gain more regulatory clarity and a larger user base, they can offer different products to cater to their audience; in some cases, it might be KYC to increase balances or offering connections with your own Lightning node, connections with multiple LSPs, eCash mints or encouraging you to sweep funds on-chain or towards the Liquid Network.
So, what should you do?
Consider your needs and comfort level. A custodial wallet with a lower cap might suffice if you’re a small-time user primarily making micropayments.
However, as you become a heavier user or you start to command a larger balance and require substantial transactions or long-term hodlers, upgrading to a non-custodial wallet offering greater control and flexibility will be your only reliable option.
If you’re comfortable running a Lightning node, you could turn to options like:
- Blue wallet
- Blixit wallet
- Zap wallet
- Zeus wallet
If total sovereign Lightning is a bit too far for you now, and you’re looking for a little support, there are LSP-supported Lightning wallets like:
- Breez wallet
- Green wallet
- Mutiny wallet
- Phoenix wallet
Alternatively, if you’re okay with the amount and fees involved, you can keep using your capped custodial wallet for smaller balances and sweep your funds into an on-chain hot wallet or cold storage. If fees are an issue or you want to consolidate your UTXOs on the cheap, then sweeping funds to a Liquid wallet instead with services like Boltz exchange is another option.
Liquid wallets are pretty scarce, but this could change with the popular browser wallet Alby launching support for the Liquid Network, and with fees remaining high, it could encourage more wallets to add support for the side chain.
Another browser wallet, Marina, traditionally a Liquid wallet, has also rolled out support for interacting with the Lightning network, so users can hold L-BTC and still pay Lightning invoices or receive funds via Lightning.
Every option has its trade-offs, so carefully research any wallet before entrusting it with your funds and become familiar with the process of using software or alternative networks before committing real capital towards these solutions.
Shared Lightning balances looking a lot more attractive
The Lightning Network is still evolving; custodial wallets with caps are just one piece of the puzzle that might need to be eliminated over time as a possible point of failure, censorship or worse confiscation of funds.
The current state of the Lightning Network encourages custodial wallet use, with not only technical issues in wallet management but Lightning apps offering native wallets to easily onboard clients, for example, Stacker News and Fountain all over in-built wallets to make it easier for users to fund accounts and begin using their services.
Offering this service might reduce barriers in terms of user experience. Still, it now opens app developers up to regulatory scrutiny, which can stunt the growth of these apps in other ways.
As the technology matures and regulations adapt, we might see this development in shared balances, where Lightning apps can tap into existing non-custodial wallets or LSPs instead, allowing everyone to enjoy the full potential of this revolutionary payment system.
