As more people find their way into Bitcoin, it puts pressure on block space, the limited resource available every 10 minutes. That limit might not be obvious right now, but we have reached periods where demand has reached the upper bound.
The mempool doesn’t tell us the full story either, since a lot of Bitcoin settlement is also completed off-chain through exchanges, OTC desks, Spot ETFS & trading of Bitcoin equities.
If these vehicles didn’t exist, we would all be queuing up for 3-5 day transactions as the norm.
If Bitcoin is to scale to billions of users, it cannot rely solely on the good graces of large custodians; it requires protocol-level scaling.
So far, Lightning has been the best bet, but even Lightning in its current form has its limitations.
Lightning requires users to run a node, commit capital upfront, and manage channels and capacity, which is a big ask for the average user. Although LSPS and Cloud Nodes are making this a little easier, protocols like Ark promise to tackle this burden.
As work on Lightning continues, other working solutions offer alternatives to Bitcoin’s scaling challenges. Sidechains like Liquid and Fediment leverage a federated custodial model as an alternative to Lightning’s 2-of-2 multi-sig.
Users can spin up compatible wallets that leverage these alternative settlement options, such as federated eCash (Fedimint) and federated side chains (Liquid). These settlement networks are easier to use when compared to Lightning, but there is a trade-off involved.
Fedimint, much like the Liquid Network, functions more as a regulatory arbitrage mechanism than a true scaling solution for Bitcoin.
I’ve been guilty of using ‘scaling’ as a catch-all term; it’s easier to use than to explain the nuances to a normie, but as a normie transitions to a maxi and commits more of their capital to the Bitcoin ecosystem, the differences become important.
What is Fedimint?
Fedimint is a federation-based custody system that leverages the concept of Chaumian e-cash to facilitate Bitcoin transactions. It combines Bitcoin multi-sig as the base for its federated security model while offering privacy-enhancing technology with e-Cash, allowing users to transact with Bitcoin through trusted federations of custodians who collectively manage funds.
In a Fedimint setup:
- Users deposit their Bitcoin with a federation of guardians
- The federation issues Chaumian e-cash notes that represent the deposited Bitcoin
- Users can transact privately and quickly using these notes within the federation’s ecosystem
- Bitcoin can be withdrawn back to the main chain or Lightning when needed
While this arrangement offers advantages in terms of privacy and transaction speed, it fundamentally alters the trust model that makes Bitcoin revolutionary.
The eCash tokens have no enforcement rights to the underlying Bitcoin, and you are relying on the group to honour the burning of eCash tokens to redeem the underlying Bitcoin.
Comparison to Liquid Network
The Liquid Network, developed by Blockstream, shares striking similarities with Fedimint in terms of being a federated system.
Liquid operates in a similar fashion, with a federation of blocksigners managing its blockchain and transferring LBTC (Liquid Bitcoin). Additionally, core federation members manage the issuing and redemption of Bitcoin based on the multi-sig that holds the Bitcoin pegged in the Liquid sidechain.
Similarities:
- Both rely on federations of trusted entities rather than Bitcoin’s permissionless consensus
- Both move transactions off the main Bitcoin blockchain
- Both reintroduce elements of trust that Bitcoin was designed to eliminate
- Both offer privacy advantages compared to on-chain transactions
- Both provide faster settlement than Bitcoin’s main chain
Differences:
- Liquid uses a different technical implementation (federated sidechain vs. Chaumian e-cash)
- Liquid’s federation members are primarily businesses and exchanges, while Fedimint can be organized by communities
- Liquid focuses more on inter-exchange settlement, while Fedimint targets community banking
Despite these differences, both systems fundamentally represent the same approach: trading Bitcoin’s trustless security for speed, privacy, and regulatory flexibility.
The Core Issue: Changing Bitcoin’s Trust Model
Bitcoin’s primary innovation is its trustless, permissionless nature. The entire system is designed so users can verify everything themselves without relying on trusted third parties.
As the famous saying goes: “Don’t trust, verify.”
But federations, by design, reintroduce trust requirements:
- Users must trust the federation guardians not to collude
- The security model shifts from Bitcoin’s decentralised consensus to a federated trust arrangement
- Custody of funds moves from self-sovereign control to collective custody
This shift in the trust model is precisely why federated custodians should be understood as a regulatory arbitrage play rather than a scaling solution.
Federations or a Fantasy?
Federations are custodians; they happen to be several custodians in geographically dispersed areas, each holding the key to a multi-sig wallet, so no single entity can make off with the money without colluding with everyone else.
The complexity of collusion and the incentive to earn fees is what users hope would be enough to keep a federation from rugging its users.
Diffusion of Responsibility
When a single entity acts as a custodian for Bitcoin (like an exchange or bank), regulatory frameworks have a clear target. That entity must:
- Register as a money transmitter or financial institution
- Implement KYC/AML procedures
- Report suspicious activities
- Maintain specific capital requirements
- Submit to regular audits
In contrast, federations distribute custody across multiple entities.
This raises fundamental questions:
- Who exactly is the custodian?
- Which entity should register with regulators?
The collective responsibility model creates regulatory ambiguity that can be exploited.
Jurisdictional Arbitrage
Federations can strategically place guardians across different countries with varying regulatory approaches to digital assets. This creates several advantages:
- Regulatory Fragmentation: No single regulator has complete jurisdiction over the entire system
- Forum Shopping: Federation designers can select favourable jurisdictions for different aspects of operations
- Enforcement Challenges: Taking action against a federation requires coordinated effort from multiple regulatory bodies across borders
The “Community Banking” Shield
Fedimint, in particular, often presents itself as a “community banking” solution rather than a financial service provider. This framing helps because:
- Small, community-based financial arrangements often fall under different regulatory thresholds.
- Peer-to-peer financial activities generally face less regulatory scrutiny than commercial services
- Religious, cultural, or community-based banking alternatives have historically received certain exemptions.
Technical Opacity
The technical implementation of federations introduces privacy features that complicate regulatory oversight:
- Chaumian e-cash protocols in Fedimint make transaction monitoring difficult
- The private nature of inter-federation transactions limits transparency
- The separation from the public Bitcoin blockchain removes a key regulatory monitoring point
Collective Governance as Defence
When regulators question federation operations, the collective governance model provides a built-in defence:
- No single entity has unilateral control
- Decision-making is distributed
- The federation can claim to be merely providing infrastructure, while users control their assets.
Regulatory Arbitrage, Not Scaling
Regulatory arbitrage occurs when entities structure their operations to take advantage of regulatory differences or gaps between different local governments.
Both Fedimint and Liquid Network operate in this manner:
1. Moving Activity Off-Chain
By moving transactions off Bitcoin’s main chain, these systems can operate in regulatory grey areas. Activities within the federation are not directly visible on Bitcoin’s transparent ledger, which creates privacy but also potential regulatory blind spots.
2. Jurisdictional Flexibility
Federations can strategically position guardians across different jurisdictions, making comprehensive regulation more difficult. This multi-jurisdictional structure provides legal insulation against regulatory actions in any single country.
3. Blurred Responsibility Lines
The shared responsibility model of federations diffuses accountability, making it unclear which entity bears regulatory responsibility for the system’s operation.
What True Bitcoin Scaling Looks Like
Genuine Bitcoin scaling solutions maintain or enhance Bitcoin’s core properties rather than compromising them.
Examples include:
Layer 2 Solutions:
- Lightning Network builds directly on Bitcoin’s security model while enabling faster, cheaper transactions
- It maintains the trustless, permissionless nature of Bitcoin while improving scalability
- Offering users direct protocol interaction and unilateral exit.
Protocol Improvements:
- Taproot and Schnorr signatures enhance efficiency without changing the trust model
- SegWit increased block capacity while maintaining Bitcoin’s security guarantees
The critical difference is that these solutions scale Bitcoin itself rather than creating alternative systems with different security properties.
Understanding the Trade-offs Before You Commit Your Sats
Fedimint offers genuine benefits in specific contexts, particularly for communities seeking private, lower-cost transactions with some degree of collective security. However, calling it a scaling solution for Bitcoin misrepresents its fundamental nature.
What Fedimint and Liquid Network truly represent are trade-offs: exchanging Bitcoin’s trustless security for practical advantages in speed, cost, and regulatory positioning. These systems don’t scale Bitcoin itself—they create alternative environments with different security assumptions.
As the Bitcoin ecosystem continues to evolve, understanding these distinctions becomes crucial. Fedimint may have its place in the broader Bitcoin landscape, but we should recognise it for what it is: a regulatory arbitrage mechanism that offers benefits at the cost of Bitcoin’s core innovation—elimination of trusted third parties.
For users, developers, and investors in the Bitcoin ecosystem, clarity about these trade-offs is essential for making informed decisions about which solutions truly advance Bitcoin’s mission versus those that merely circumvent its existing limitations through compromise.
