Bitcoin: Despite Headwinds, The Merchant Solution Is Evident

When I last covered Bitcoin (BTC-USD) in early July, I made the argument that bearish Bitcoin had become a one-sided trade. While Bitcoin is lower now than it was at the time of that article, bulls did get a relief rally that took the coin from $21k at time of writing to $25k within a few weeks. Sentiment is once again bearish, this time though I don’t see the same contrarian opportunity. This article will instead focus on the technical drawbacks of Bitcoin, the Lightning Network and its activity, and the broad macro headwinds currently facing all risk markets.

Network Drawbacks

One of the big technical flaws on Bitcoin’s base layer is the lack of scalability. While Visa (V) can reportedly process tens of thousands of transactions per second (or TPS), Bitcoin can handle less than 10. This, rightfully, leads many to be highly skeptical of Bitcoin’s theoretical mass adoption as a peer to peer payment network. It is also a big reason why there has been a proliferation of other blockchains that aim for better scalability through higher transactions per second figures.

• Solana (SOL-USD) claimed 50,000 TPS on testnet, though others suggest real capacity is far lower than that
• Avalanche (AVAX-USD) claims to be able to process 4,500 TPS

The scalability problem for Bitcoin, and Ethereum (ETH-USD) as well, is highlighted through what has been dubbed the “blockchain trilemma.”

Essentially, the three desirable traits needed from public blockchains are security, scalability, and decentralization. What we’ve seen so far is all of these public blockchains can achieve two of the three traits. None of them have achieved all three. For instance, Bitcoin is secure and decentralized but not scalable. Most of the high TPS blockchains are able to achieve the scalability at the expense of decentralization or security. While Ethereum has level two options like Polygon (MATIC-USD) and Arbitrum that aid in scalability, Bitcoin’s best shot at addressing scalability currently is the Lightning Network.

Lightning Network

Joseph Poon and Thaddeus Dryja published the Lightning Network white paper back in 2016 specifically to address Bitcoin’s scalability problem. Recognizing that inexpensive Bitcoin micropayments only being possible through custodial solutions defeats the entire purpose of a peer to peer network, the authors proposed a “channel” based option that doesn’t utilize the base layer chain for every transaction:

Instead, using a network of these micropayment channels, Bitcoin can scale to billions of transactions per day with the computational power available on a modern desktop computer today. Sending many payments inside a given micropayment channel enables one to send large amounts of funds to another party in a decentralized manner. These channels are not a separate trusted network on top of bitcoin. They are real bitcoin transactions.

The channels are a bit like a tab at a bar. When the customer gives the bartender his/her credit card, the two parties have agreed to open a “channel” that won’t be closed until the customer decides to leave the bar. If a Lightning user wants to pay for a coffee with Bitcoin and the coffee shop has a Lightning Network node, the two parties can open a channel between each other that will allow to the customer to pay for coffees any number of times at a cost that equates to less than a penny per transaction.

What’s also interesting about the network is users don’t necessarily have to open channels with every merchant they do business with. The map above shows the channels currently active on the Lightning Network. If adoption reaches a critical mass, Lightning can route payments through channels that have several degrees of separation. This means the network will allow transfers between two users that don’t have an open channel as long as there is a connection somewhere in the network that links the parties together.

For instance, let’s say “Customer 1” has a Lightning channel with a grocery store but not with a restaurant. The restaurant has an open channel with “Customer 2” and “Customer 2” also has a channel with the same grocery store, “Customer 1” and the restaurant can transact without opening a channel because the Lightning Network will route the payment through “Customer 2” and the grocery store.

Currently, there are roughly 81k channels on the network. While the channel trend has stagnated since the crypto market topped late last year, total channels on Lightning are up roughly 19% year over year. The real growth on the Lightning network is in the capacity, or the amount of Bitcoin that is available to be transacted on the layer:

There are now 4,740 Bitcoins available to transact on the network, or roughly $105 million in funds. While the BTC capacity has grown 91% year over year, the dollar purchasing power of that capacity is down 5% because of Bitcoin’s price struggles year to date.

So why would a merchant have any desire to do this? Transaction costs on Lightning are drastically cheaper than traditional payment processors like Visa. We’re already seeing merchant fatigue from those processing fees. Just this week we see reports of Target (TGT) and Walmart (WMT) supporting a bill to lower credit card fees.

The bill, which Sen. Richard Durbin (D., Ill.) and Sen. Roger Marshall (R., Kan.) introduced in July, would give merchants the right to route many credit-card payments over networks other than Visa and Mastercard. In a letter this week to all members of Congress, the merchants said the proposed legislation would increase competition, leading to a reduction in the fees they pay when they accept credit cards.

Rather than trying to fight pricing battles through the state apparatus, it might behoove companies like Target and Walmart to instead start running Lightning nodes and build integrations with their B&M chains and e-commerce stores. Show consumers the benefit and you’ll likely get the result you want; especially with consumer price inflation still running hot.

But the overall point is there is an enterprise appetite for cheaper transactions and Bitcoin’s Lightning network can be utilized to serve that demand. It’s important to mention that these kinds of blockchain networks can be used to transact more than just native assets. If Circle supported USDC Stablecoin (USDC-USD) on Lightning, users could transact dollars on Lightning for fractions of a penny per transaction with BTC “sats” essentially serving as the grease to keep the engine moving.

Base Layer Activity

As far as the base layer goes, we’re still seeing highs in hashrate and in several other areas:

Mean hash rate made another new all time high a few days ago. This suggests the network remains secure as a growing number of miners compete for the block reward. Additionally, active addresses are still near highs and generally oscillate between 700-900k daily users on-chain.

Despite the generally positive network usage and security metrics, the price of BTC still comes down to monetary policy.

Macro headwinds

Like every other speculative digital trinket that trades in crypto (or on the Nasdaq for that matter), Bitcoin’s price will likely come down to the Federal Reserve’s monetary policies. On Tuesday, risk markets broadly sold off because of an 8.3% year over year CPI print that came in higher than the 8.0% forecasts. There are now many who are calling for September rate hikes that are higher than was expected just a few days ago:

The market is now pricing a 30% chance of a 100 basis points rate hike next week. This is up from 0% on Monday. Bitcoin has survived several bear cycles that have led to extreme drawdowns. But Bitcoin hasn’t yet been tested in a legitimate tightening cycle like the one currently being guided. While I personally question how much higher rates can go without causing systemic problems, all risk markets are going to struggle until there is a clear indication that the Federal Reserve is taking the foot off the gas on rates.

Summary

Bitcoin has a tough road ahead. In addition to the monetary policy headwinds, the current administration is reportedly weighing action against domestic Bitcoin mining. Furthermore, the energy consumption narrative that goes with Proof-of-Work mining is likely to get louder following Ethereum’s merge to Proof-of-Stake. But Bitcoin’s Lightning network theoretically addresses this concern as well because the transactions are off-chain.

As I’ve explained here and in a previous article, it is in the merchant’s best interest to use something like Lightning if the user interface can be simplified. It is undeniably cheaper for the goods and services seller to use Lightning for payments rather than credit cards. We’re already seeing top US retailers supporting a bi-partisan bill aimed at lowering credit card transaction fees. The market demand for alternatives appears to be there. The question is will that demand find its way to Bitcoin’s Lightning Network. And if so, does that mean the BTC price decouples from the rest of the market? If it does, bulls should see phenomenal gains. If it doesn’t, Bitcoin will continue to trade like a risk asset. In a tightening cycle, long-term bulls should pick their spots adding on dips like the one we got on Tuesday.