Author: ZmnSCPxj 2018-12-27 05:43:51
Published on: 2018-12-27T05:43:51+00:00
The Lightning Network is a system that allows for cross-currency on-Lightning exchange. While it has the potential to perform seamless currency conversions, there is a significant technical barrier preventing implementation of such a feature. This is due to the use of hashlocked timelocked contracts (HTLCs) to route payments.HTLCs can be used to transfer value between cryptocurrency systems and also to construct American Call Options. On the Lightning Network, there is no cost incurred in merely setting up HTLCs for routing, which means that these on-Lightning American Call Options can potentially be "purchased" for free and earn money in a completely risk-free manner. This poses a risk to any Lightning Network node advertising cross-asset on-Lightning exchange as their liquidity may become tied up in stalled forwarding payments with a risk of monetary loss in case of large fluctuations in exchange rate.An American Call Option is a right to purchase an asset at a specific price on or before an expiration date. HTLCs allow building American Call Options between different cryptocurrency systems. Each channel is its own cryptocurrency system. For instance, ZmnSCPxj could act as an intermediate node on Lightning and facilitate payment between a payer and payee. Some Lightning Network nodes advertise themselves as providing exchange capability, taking one asset on one channel and exchanging it for another asset on a different channel. This poses a risk as cross-asset Lightning nodes offer premium-free American Call Options. Suppose ZmnSCPxj advertises as such an exchange, and a person wants to pay someone else for 1 WJT but only has bitcoins on hand. ZmnSCPxj has a bitcoin channel with the payer and a WJT channel with the payee. This setup inadvertently creates an American Call Option for no premium when the intent was to facilitate cross-currency Lightning Network payments.However, this could lead to significant liquidity being tied up in these options and exchanges losing funds, particularly during times of volatility. The problem arises due to the fact that payment failures are free on the Lightning Network, which means setting up an American Call Option is premium-free, even if expiration is near. There are proposed solutions to mitigate the issue, but all have significant drawbacks.One solution is to force setting up HTLCs to require payment, which would add a premium to the American Call Options. However, this would make routing failure non-free, and the current Lightning Network works well because routing failure is free. Another solution is to increase fees, which would reduce risk, but rational entities would still tie up most of the liquidity on the exchange. The third solution is to limit the timelock of cross-asset swaps, but this would increase friction for crossing assets.In conclusion, while HTLCs allow for the creation of American Call Options, they become problematic when used across different assets since it can be exploited to earn money from exercising the option. This makes creating such options riskless, allowing potential earnings upon strong volatility of exchange rates. Therefore, a multi-asset Lightning Network may not be economically viable, and instead, the network would strongly prefer having a single asset across the network.
Updated on: 2023-06-02T16:16:58.873087+00:00