Author: CJP 2018-12-28 08:27:11
Published on: 2018-12-28T08:27:11+00:00
The Lightning Network is a unique way to transfer value between cryptocurrency systems. It uses hashlocked timelocked contracts (HTLCs) for routing payments. HTLCs can also be used to perform cross-system trades, making participation on any single Lightning Network channel available to the entire network. However, HTLCs can also be used to construct American Call Options, which are a right to purchase an asset at a specific price, on or before an expiration date. The unintended consequence of the network is that users can construct American Call Options without any premium, allowing for riskless earnings upon any strong volatility of exchange rates. This could lead to significant liquidity being tied up in these options, potentially causing problems during times of volatility. Traditional options have a premium that is the risk of the user, but payment failures are free on the Lightning Network. Therefore, users can construct American Call Options without any premium, allowing for riskless earnings upon any strong volatility of exchange rates. To set up an American Call Option with expiration of 1 day from now, one needs to provide a hash whose preimage only they know and set up an HTLC on the bitcoin channel and another on the WJT channel. The value of the bitcoin HTLC is `P`+1 bitcoin (the 1 being the fee), and the hash provided is the one created by the user. The timelock is 2 days from now. On the WJT channel, the value is 1 WJT, and the hash provided is the one given by the user. The timelock is 1 day from now. If the price of 1 WJT rises above the price of `P`+1 bitcoins before the expiration, the user will release the hash and acquire the WJT, then sell it immediately to earn more than the `P`+1 bitcoins paid. Otherwise, the user will cancel the HTLCs, and since even payment errors are onion-wrapped, no one can determine whether the payment actually errored or the user decided not to exercise the option.This unintended consequence of premium-free American Call Options could make multi-asset Lightning Networks economically unviable, leading to a preference for a single asset across the network. There are solutions proposed to mitigate this issue such as forcing payments when setting up HTLCs, which would require accurate knowledge of channel balances and increase friction in crossing assets. Exchange nodes could also increase their fees, which would only reduce risk. Exchange nodes could limit the timelock of cross-asset swaps, which would increase friction in crossing assets and lead to a centralized network around exchanges. However, rational entities will still tie up most of the liquidity on the exchange on riskless American Call Options, even if the exchange rate is very stable in short time frames. The author suggests that trustlessness creates risks, but if the alternative trustless system is very impractical, and the risk is small enough, the benefits might be worth the risks. However, note that this is a subjective trade-off, so it is only acceptable on an individual, voluntary basis. The author proposes a solution to the problem in their proposal, but it is not completely trustless.
Updated on: 2023-06-02T16:08:32.277246+00:00