REFLECTION:
For normal Bitcoin users, the volatile market might not be an issue in terms of using Bitcoin to pay for goods and services, because perhaps they acquired their coins at a lower price or earned them through other means, but for the merchant who must run their business, especially on the Fiat standard, what is their fate in accepting Sats for payment?
INTRODUCTION
Unexpected volatility and market corrections like the one we are currently experiencing are one of the major factors that shake the foundation of Bitcoin's use as "money" or "a medium of exchange", and it is the major contributing factor to why millions of people who understand Bitcoin may still consider it only useful as a "Medium of Storing Value".
It is important to emphasize that Bitcoin's use as a medium of exchange is inherently negatively affected by Bitcoin's Fiat valuation fluctuation, a.k.a. Bitcoin Price volatility, a natural attribute associated with free-market monies/financial instruments like Bitcoin, and also a compulsory path which Bitcoin must tread towards becoming a global means of exchange, and consequently a unit of accounting.
Bitcoin is obviously the best form of money in the world due to obvious reasons, but we are still in the wee hours of Bitcoin's life cycle when compared to other forms of money and their aged history. Hence, there's still a long journey ahead before Bitcoin reaches a relatively stable valuation, or at least achieves a drastically low and infrequent price volatility.
But, as we gradually navigate through Bitcoin's life cycle, does it then mean that we cannot use Bitcoin as a medium of exchange yet? The answer is an obvious "NO", because anyone can exchange Bitcoin for any other value or services. However, the aim is to be able to spend Bitcoin for everyday value, such as paying for groceries, gas, hotels, flight tickets, etc. The good news is that we can now do all of these, thanks to incredible Lightning wallet solutions and merchant Bitcoin POS solutions being developed from all sides in the industry.
These solutions, however, may not completely solve the issues associated with Bitcoin's price volatility in terms of its use as day-to-day money, especially for merchants, without incurring Bitcoin-to-Fiat conversion charges. Most of these solutions are also largely KYCed, and hence easily censorable.
On the other hand, the world is still largely run on the Fiat standard, which suggests that over 99% of global businesses (large, medium, or small) still run business accounting operations in Fiat accounting units/standard. Hence, if Bitcoin were to be widely used as a medium of exchange, given its inherent price volatility, it'd mean that average businesses that wish to accept Bitcoins for payments would either constantly exchange them for fiat on receipt, to make sure their books balance, which in turn incurs exchange fees and compulsory KYCing, or they’ll temporarily stay out of business when there’s a market correction.
Imagine a merchant who accepted Sats for their products last week when Bitcoin was valued at $105,000/BTC and did not instantly convert them to Fiat. How do they get to restock their products this week when Bitcoin is valued at less than $85,000/BTC (as at the time of this writing)?
The above situation leaves us between the Devil and the Deep Sea. Maybe they should just accept Fiat, which in turn halts or slows down the use of Bitcoin as a means of payment in everyday commerce.
It is because of such Bitcoin market situations, and all of the issues highlighted above, that Hosted/Fiat Lightning channels were designed.
HOSTED/FIAT LIGHTNING CHANNELS:
Fiat channel is a derived concept from the original Lightning implementation called "Hosted Channels", proposed by Anton Kumaigoroski and initially implemented in the now unmaintained Simple Bitcoin Wallet (SBW) and IMMORTAN library.
HOSTED CHANNELS
Hosted channels are a lesser-known type of Lightning channels that have no on-chain funding, but otherwise work according to standard self-custodial LN rules. The notable differences between a Hosted/Fiat channel and a normal Lightning channel are:
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Uses a Client/Host relationship whereby the Client code is to be implemented in end-user LN wallets, and the Host is a service which is to be provided by willing businesses by running a Lightning node alongside the unified open-source Hosted channels protocol.
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Funds in a Hosted channel are a pure Host's IOU to the Client side, hence they're not automatically enforceable on-chain but are cryptographically auditable. A normal Lightning channel provides enforceability by means of a "cross-signed commitment transaction"; however, a Hosted channel provides auditability by a notion of "the latest cross-signed state," which can be used to prove the Host's obligations.
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Just like normal Lightning channels, Hosted channels provide privacy guarantees. The Host does not know who the Client is and has no metadata on the Client's payments because route selection, onion formation, and preimage generation for incoming payments still happen on the client side.
The main motivations behind the development of Hosted channels are these:
A. Radically Simplified UX and Zero on-chain footprint:
Hosted channels can be created on the fly with zero on-chain fund allocation on either the Host or Client side, providing a drastically easier Lightning on-ramp for Bitcoin users, especially people who are less technically inclined.
B. Improvement on current hosted/custodial Lightning implementations:
Hosted channels are auditable and privacy-preserving improvements over current hosted LN wallets, and they can exist alongside normal channels in autonomous or self-custodial Lightning wallets, like SBW and Valet.
FIAT CHANNELS
Fiat channels retain all the features of Hosted channels, but with an additional tweak that makes them different. They differ from Hosted channels because they permit the tracking of the price of an asset (Bitcoin) and cryptographically authenticate it on the Lightning Network.
Here are two specific things that make Fiat channels different from Hosted Channels:
- It adds a special field into the channel state for tracking "last exchange rate". Thus, the amount of satoshis in the channel and the last rate corresponding to the "last cross-signed state" represent a constant synthetic fiat-denominated value.
The simple explanation of this concept is that when a client receives sats, the system tracks the Bitcoin price at that moment, records the fiat value of the sats received as a stable balance, and then tracks the number of Sats received at that time.
As Bitcoin’s price fluctuates, the client's Sats balance adjusts automatically to ensure that the fiat value stays stable. This is possible because the channel always remembers the last Bitcoin exchange rate used when the client and the Host agreed on the initial Fiat and Sats balance (the “last cross-signed state”).
- Fiat channels leverage the resizing feature of the Hosted Channels, which helps to tackle sharp downward volatility of the Bitcoin exchange rate and preserve the purchasing power of the channel user.
How this works in simple terms is that when a client receives Sats to the channel, say $100 worth of Sats at $100k/BTC, automatically, the $100 value is locked in as a synthetic stable balance, and the Sats value, which is 0.001 BTC, is also recorded but left floating with the Bitcoin price.
So, when Bitcoin’s price goes up or down, normally, the Fiat value of that 0.001 BTC should adjust accordingly, but instead, the reverse is the case. The Fiat balance stays put while the Sats value adjusts. This is possible because of the resizing feature built into Hosted channels.
So through Fiat channels, a client (In this case, a merchant) can easily open a Lightning channel (anonymously), and start receiving Sats payments on the go without the need to commit any liquidity, and without any form of KYC.
When a merchant receives Sats on their channel, the Fiat value of the Sats is locked in as described above; hence, at any point in time, this merchant can send out/spend Sats worth their locked-in Fiat balance, regardless of the price of Bitcoin at that point.
This solution offers an easy on-ramp to Lightning, eliminates the need for constant conversion into fiat which results in fees and compulsory KYC, ensures that the merchant who runs their business on the Fiat standard can still successfully balance their books and stay in business, whether in a bull or a bear season while still enjoying all the benefits of using the Lightning Network for payment.
It is important to note that what the client spends are Sats, hence, transactions to and from never need to leave the Bitcoin rails. So, a merchant can pay their supplier through Lightning, as well as receive payments through Lightning, actively promoting the use of Bitcoin as a medium of exchange, and enshrining the Bitcoin Standard.
As already implemented in Valet, a self-custodial Bitcoin/Lightning wallet, it is important to note that at any point in time, the client can sweep their Fiat channels balance into their normal Lightning channel, making it easy to switch from custodial to self-custodial usage of Lightning.
The possibility that any institution, business, or entity that has the capacity can run a Lightning node with the Hosted/Fiat channels protocol plugin, and offer this service to clients, somewhat makes this solution decentralized.
Hence, clients do not have to depend on one centralized Host like “Standard Sats” to use this service, in stark contrast to what is obtainable with most traditional Custodial Lightning-hosted solutions today.
This removes a single point of failure and creates enough Host options for clients to choose from. It also ensures a self-regulated, healthy Host competition, since there’s no monopoly on this service.
Clients can switch Hosts at any point in time without worrying about unsolicited marketing emails and customer retention emails, which is often the case in centralized, KYCed systems.
THE HOST - Maintaining Stability
At this point, the reader might be wondering, "How does the Host ensure that the client can always send out payments, especially in sudden, volatile moments like the one we are in?".
This is where a "Hedging algorithm" comes in.
We (Standard Sats) have already designed a hedging solution that ensures a 1:1 protection of the client's synthetic stable Fiat balance. This hedging software automatically opens a short perpetual Bitcoin contract on an exchange, covering the total amount of all clients' Fiat balances, constantly adjusting this position as these clients spend and receive sats. This is the only way the Host can protect the client's stable balance at all times, regardless of the price of Bitcoin at any point in time.
CONCLUSION
We have seen the rise in Bitcoin’s use as a medium of exchange across global Bitcoin circular economies. We have also seen an increase in the development and deployment of both wallet solutions and Lightning payment solutions for this cause, with the most recent and profound one being Square's smart merchant POS.
In all of this progress, we may have rarely considered the striking need of merchants who run their businesses on the Fiat standard, needing to balance their books and restock their wares (whether it is raw materials, finished goods, or talents), while gradually adopting a Bitcoin Standard.
In fact, if merchants are not willing to, or do not entirely accept Bitcoin as a means of payment, then Bitcoin's role as money may not be achieved. It is also important to emphasize that at first, not all merchants are Bitcoiners. Most of the merchants who will eventually accept Bitcoin as a means of payment are people who most likely do not even understand it.
Bitcoin's volatility is an obvious challenge to its role as a medium of exchange, particularly for day-to-day micro businesses, which means that merchants must continuously rely on fiat rails for conversion to balance their books and stay in business, incurring extra fees and other possible issues.
Hosted/Fiat channels solved most of these problems by removing one point of attack through decentralized Host distribution, Host/Client record auditability, and removing the issue of KYC. The client side can be implemented alongside a normal self-custodial Lightning channel, as implemented in Valet, enabling merchants to become self-custodial at any point by sweeping their Fiat channel balances into their normal channels without permission.
With the Fiat channel solution, more merchants can now easily get onboarded, enjoying the borderless and seamless benefits of Bitcoin Lightning payments without concerns about Bitcoin’s volatility. This is a temporary and necessary step towards the gradual establishment of a global Bitcoin standard.
The Hosted/Fiat channels project is still in progress, and we are calling on every Bitcoiner (developers and users) to join us in building the next phase of Bitcoin merchant adoption.
Please, download Valet today, create an account, set up a Fiat channel by scanning the QR code below, and share your thoughts.
Visit our GitHub page to review the project. Feel free to fork it, suggest features, and drop your contributions. Together we can grow and expand the global Bitcoin economy on the Bitcoin Standard, one client at a time!!
MORE RESOURCES:
Hosted Channel RFC: https://github.com/standardsats/hosted-channels-rfc
Fiat Channel RFC: https://github.com/standardsats/fiat-channels-rfc
Concept Digest: https://standardsats.github.io/
Valet: https://valet.finance and https://github.com/standardsats/valet
LN Liquidity Abstraction: https://medium.com/coinmonks/liquidity-abstraction-in-lightning-network-3d7a1d76ac82
By
Ugochukwu Chidire David
Product Growth Lead,
Standard Sats