The Pros & Cons Of Lightning Banks

Xapo Bank’s recent integration of Bitcoin deposits through the Lightning Network (LN) marks another step towards the adoption of Bitcoin by tradFI. For some strange reason, this dirty ocean boiling magic internet money for nerds, drug dealers and ransomware hackers has the suites interested as it smashes through the trillion-dollar market cap range. 

2024 looks like the year of the bankers. 

The spot ETF has been approved for trading in the US, while other countries like Australia and Hong Kong are set to follow up with their local versions. 

Companies other than Michael Saylors’ MicroStrategy are openly discussing adding Bitcoin to their balance sheets. Now, we have regulated banks that use Lightning rails and support Satoshi-based accounts. The Gibraltar-regulated Xapo has become the first fully licensed bank to enable Bitcoin deposits via the Lightning Network.

The move builds on Xapo Bank’s introduction of Lightning-powered pre-defined small payments of up to $100 in March 2023 in collaboration with Lightning Network infrastructure firm Lightspark.

While some will celebrate the improved access to Bitcoin, encouraging users to leverage existing service providers instead of fly-by-night exchanges, the adoption of Bitcoin in tradFI comes with its own set of advantages and disadvantages that users should consider before diving in. 

What is the Lightning Network?

Before diving into the specifics of Xapo Bank’s implementation, it’s crucial to understand the Lightning Network itself.

Bitcoin, by design, prioritises security over speed. 

Transactions are recorded on a public ledger, ensuring transparency but leading to slower processing times, especially with increasing network traffic. The Lightning Network acts as a second layer built on top of Bitcoin, facilitating faster and cheaper microtransactions.

Here’s how it works: 

Imagine two people wanting to conduct frequent, small-value transactions. Instead of broadcasting every single transaction to the main blockchain, they establish a secure payment channel on this second layer. 

This channel allows them to send and receive payments back and forth or broadcast a payment to be passed on via several hops until it reaches its destination. When a channel owner is ready, they can depart the Lightning Network with their updated balance.

The final settlement happens on the Bitcoin blockchain only when the channel is closed, ensuring security without bogging down the main network.

Pros of Lightning Network banking

Faster transactions

One of the most significant advantages of LN-enabled banking is the drastic improvement in transaction speed. While the end user might not notice too much of a difference, LN settlement is miles ahead of anything provided by fiat payment rails. 

The complexity of modern electronic payments is hidden from users, with the banks taking on the liability of providing users with immediate settlement. Unlike traditional payments, which settle periodically and require banks to consolidate payments in batches with their various counterparties, LN moves the bearer asset immediately, making it ready for spending again. 

LN transactions are nearly instantaneous, making them ideal for everyday purchases or micropayments.

Reduced fees

While running a Lightning node as an individual might seem like a burden, it’s a much more attractive proposition if you’re running one as a custody provider. 

The Lightning Network can reduce the technical overhead of managing and settling payments as a bank. A custodian can deploy capital to their node and create channels of various sizes, from smaller channels for infrequent payment routes to wumbo channels for settlement between popular destinations. 

The bank can absorb this reduction in operating costs as profit or pass it on to the customer with cheaper transaction and management fees, using this as a USP to attract more customers.

Integration with existing systems

With the integration of services like Xapo Bank’s LN deposits, users can leverage LN’s benefits without needing extensive technical knowledge. Think of it as a custodial wallet but with the backing of a regulated entity’s balance sheet. 

Banks and other financial institutions can act as intermediaries, simplifying the process of using LN for everyday transactions.

Users who prefer to use Lightning can pay traditional account users, opening up payment routes between the Lightning ecosystem and account holders or merchants who aren’t ready to transition towards a Bitcoin standard. 

Stress testing of the network

Bitcoin’s scalability has been a major point of discussion. 

The Lightning Network offers a potential solution by taking a significant load off the main blockchain, but we’ve yet to see the Lightning Network placed under considerable strain. 

Facilitating direct interaction with Lightning XAPO and banks that follow their example will expose more users to these rails and encourage users to perform microtransactions off-chain.

This additional volume and regular use can be the ideal stress-tested to see how LN handles more users. 

Cons of Lightning Network banking

Regulation, compliance and censorship concerns

As LN banking becomes more mainstream, regulatory frameworks like money laundering and know-your-customer (KYC) compliance will apply; this could limit who you can pay and services you can interact with directly or result in your account being removed should you interact with certain entities like privacy tools or any account blacklisted as OFAC non-compliant. 

This could mean you have limited access to the Lightning Network, like interacting with only XAPO accounts or UMA-integrated Lightning Wallets, with limited access to the broader network. 

Centralisation risks

The concept of custodial Lightning Network wallets, like the one offered by Xapo Bank, introduces a layer of centralisation. Users entrust their Bitcoin to the bank to manage their LN channels, which goes against Bitcoin’s decentralised ethos. Leaving your funds with a custodian where the user has no ability to force an exit places your funds at risk should the bank become insolvent.

A string of taxable events

Xapo Bank’s integration with the Lightning Network can make it easier for tax institutions to monitor your Bitcoin transactions. Instead of having to employ chain analysis to track down your funds, spending, and taxable events, when everything is centralised in-house, your liabilities can easily be captured, processed, and reported to the local tax authority applicable to you.

As governments seek new forms of revenue, the trend of financial institutions offering tax reporting tools specifically designed for Bitcoin transactions is set to continue. It’s important to note that digital asset custodians of all kinds will have to provide these tools to comply with tax regulations, making it a necessary adaptation in the evolving financial landscape.

You can use a bank or be the bank

Xapo Bank’s integration of Lightning Network deposits is a promising development for Bitcoin banking. Should this become a popular product and revenue driver, it could set a precedent for other banks to follow. 

XAPO banks’ offering won’t be well received by everyone in the Bitcoin community. To some, it’s seen as a step back, promoting a captured trust model over self-sovereign money.

For others, it’s the acknowledgement that banks need to adopt Bitcoin technology or get left behind, effectively admitting that this is money and has value. 

Since no perfect scaling and custody solution exists today to suit everyone, users must decide on their Bitcoin and accept the risks involved. It doesn’t have to be all or nothing. Your exposure to Bitcoin can exist on a spectrum. Most of it can be in self-custody, while some you take a custodial risk with to spend on your regular expenses.

Whether LN banking is right depends on your needs and risk tolerance. 

Here are some factors to consider:

• Transaction Frequency: If you frequently conduct small-value Bitcoin transactions, LN can offer significant speed and cost savings benefits.
• Technical Savvy: If you’re comfortable with Bitcoin technology and managing your own wallets, non-custodial LN solutions might be a good fit. However, if you prefer a more user-friendly experience, custodial solutions like Xapo Bank’s offering could be more appealing.

Nevertheless, the debate between custodial and non-custodial solutions will likely continue. Custodial solutions like Xapo Bank’s offering provide convenience but introduce users to Lightning, albeit with a trade-off of centralisation. 

Non-custodial solutions offer greater control but require a higher level of technical expertise. Transitioning will take time, but exposing more users to Lightning might encourage more people to move towards a self-custody model as they realise the benefits of managing their own money.