A long-held view in both crypto markets and traditional financial markets is that in order to earn an interest on one’s assets, custody of those assets must be given up to a third-party. But with bitcoin (BTC)’s Lightning Network (LN), a new model for earning a non-custodial “Lightning Network Reference Rate” (LNRR) has emerged, one author argues.
According to Nik Bhatia, an adjunct professor of finance at the University of Southern California and author of the book Layered Money, the market for so-called routing fees on bitcoin’s Lightning Network could in the future serve as the first form of “counterparty-free income” for owners of capital.
“The smart contracts within LN allow its participants to establish a market for routing fees, and routers can earn a bitcoin-denominated return without ever relinquishing complete control of the underlying capital,” Bhatia wrote in a recent blog article on bitcoin interest rates.
He added that in traditional financial markets, returns can never be earned without trusting capital to a counterparty.
“How can a corporation, for example, return income to investors without initially taking outside capital into its own custody? Impossible,” the popular author wrote.
But while Lightning Network routing fees can be earned without giving up custody of the bitcoins that are deployed, they are still not an entirely risk-free interest rate like government bonds are usually considered to be in the traditional financial system. The network is young, and unknown risks or security loopholes may exist.
Further, routing fees are not the only interest rate that can be derived from a future bitcoin economy, the author argued.
Other potential sources of income in a future bitcoin economy could also include fees from coin mixing, bitcoin futures funding rates, or exchange deposits and lending. However, the notable difference here is that all of these activities do involve some form of counterparty risk.
Combined, all of these rates can form a “robust yield curve” in the bitcoin market, which will evolve into investment strategies entirely based on “the diversified bitcoin rates complex,” Bhatia concluded.
In the past, other attempts at establishing a risk-free interest rate for bitcoin akin to the yield curve for US and European government bonds have mostly focused on the regulated futures market for bitcoin.
Among these, one research article by Quantpedia.com looked at the rate that could be earned by going long on the front-month bitcoin futures contract on the regulated Chicago Mercantile Exchange (CME), while simultaneously going short on the longest dated (back-month) contract.
This would create a position that would not be exposed to the price swings in bitcoin, but instead take advantage of the price difference between futures contracts of different maturity.
And although the counterparty risk may be small in this case given that the CME is a regulated futures exchange, the risk is still there, and no returns can be generated without giving up custody of the bitcoins.
Others, meanwhile, agree with Bhatia’s take that the only counterparty-free interest rate on bitcoin is the one that can be derived from Lightning Network routing fees.
According to Patrick Heusser, head of trading at the digital asset brokerage Crypto Finance, a “Lightning Network Reference Rate” could even have implications for the pricing of bitcoin derivatives. This is because the rate means that the “opportunity cost of Bitcoin becomes measurable”
And judging from Heusser’s research, a Lightning Network Reference Rate could in fact have even lower risk than the assets typically considered risk-free in traditional finance.
“The Lightning Network, controversially, and the resulting LNRR is associated with less risks if the necessary knowledge is available to deal with the operational risks,” Heusser argued, before finally adding:
“Nevertheless, it is surely not wrong to consider the LNRR as risk-free if your unit of account is Bitcoin.”
In other words, it appears that fees from bitcoin’s Lightning Network may have a real chance at becoming the first-ever reference rate that is both risk-free and counterparty-free at the same time.
The old wisdom, which Bhatia summarized by saying that “returns are never earned without sending capital to a counterparty” could thus be about to be turned on its head.
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