Examining the Lightning Network and the Need for KYC

The Lightning Network holds the potential to significantly increase transaction speed and volume for the bitcoin payments system.

The network’s capacity passed 5,000 bitcoins in October after exceeding 4,000 in June. Network adoption is growing, though it remains relatively small compared with the payment giants.

“In 2021, Visa handled more than $1 trillion in payment volume and close to 20 billion transactions per month,” according to Bitcoin Magazine, citing Arcane Research. “In comparison, we estimate that the Lightning Network handled about $20 million in payment volume and slightly over 800,000 transactions in February 2022.”

What is the Lightning Network?

The Lightning Network creates a payment channel that enables quick, inexpensive bitcoin transfers for two or multiple parties.

Opening a Lightning channel first requires a bitcoin deposit locked into a joint account. The payer then transfers ownership of deposit portions to the recipient. Either party can close the channel or add to the account. When the channel closes, all transactions are combined and sent to the main bitcoin blockchain, which then settles and validates the account.

That leads to far faster transactions and lower fees. The network can handle 1 million transactions per second, compared with seven per second in the bitcoin blockchain. Lightning Network transactions are instant, while those through the bitcoin blockchain can take more than an hour to settle if the network is crowded.

In June 2022, the average bitcoin transaction fee was $0.73, but reached as high as $34. Transactions through Lightning are less than a penny.

Lightning, KYC and regulations

Sending money through the network can be particularly ideal when the parties trust each other and perform multiple transactions in a Lightning channel. For example, a family member sending remittances back home can pay low fees and avoid other third parties.

In other instances, security concerns can arise. If one party goes offline, for example, the other party can take the money in the account through an offline transaction scam.

A Lightning channel could run thousands of transactions with only the opening and closing requiring the bitcoin blockchain. While that creates more private transactions, it also limits audits that could identify money laundering and other financial crimes.

In general, financial regulators expect payment systems to have licenses and follow Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements. For example, the U.S. Financial Crimes Enforcement Network considers any service that transmits “currency, funds, or other value that substitutes for currency to another location or person by any means” a money transmission service that falls under regulations.

Lightning transfers value, so regulatory obligations could apply to organizations that use the network. Understanding how payments and crypto companies are regulated and deploying best practices can help prevent regulatory scrutiny.

Payments innovation and opportunity

Coinbase, in considering the Lightning Network’s future, suggests “the potential to turn crypto’s most valuable asset into a true medium of exchange has the power to bring greater financial inclusion to anyone with a smartphone.”

Lightning holds promise for instant payments, microtransactions and ultra-low fees. It’s a prime example of how digital payments present innovative opportunities for organizations.