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Crypto Daily Topic

Lightning network: A major hurdle in the path of crypto regulation

The very first public critique of Bitcoin right after Satoshi Nakamoto proposed it was made by James A. Donald. He said that while such a system (Bitcoin network) was very, very much needed, the way he understood it, “it does not seem to scale to the required size.” Sure enough, over a decade after its launch, Bitcoin is being plagued by scalability problems – apparently its biggest challenge. But there is another less discussed one: taxation.

For a long time since its rollout, Bitcoin was used primarily by enthusiasts and speculators more as a store of value than a medium of exchange in everyday payments. Bitcoin has a serious scalability problem for two main reasons: the blockchain technology on which it runs limits the amount of information that a single block can contain to 1 megabyte, and a block of transactions can only be added to the chain every 10 minutes. These limit Bitcoin’s processing speed to about 3.3 and 7 transactions per second (TPS). In comparison, Visa does an average of 1,700 transactions per second.

Enter the Lightning Network

Today, more people are adopting Bitcoin to make everyday payments, largely because of the development of the Lightning Network. Popular Bitcoin apps such as Fold and Bitrefill that are designed to make it cheaper and easier for users to make payments with Bitcoin have integrated the Lightning network in their payment systems.

What is the Lightning Network?

The Lightning Network is an additional layer on top of the blockchain network on which Bitcoin runs that is designed to make transactions between nodes faster and cheaper. It is implemented to be a solution to Blockchain’s scalability problems.

How does it work?

The Lightning Network creates a temporary communication channel between two nodes, much like how the Bitcoin Network does, allowing them to carry out as many transactions as they need. When the transactions between the two nodes are completed, the channel is closed, and the outcome communicated to the underlying Bitcoin network. Transactions carried out on the Lightning Network will, as a result, cost only a fraction of a cent while taking a load off the Bitcoin Network.

There is a problem, though. While the Lightning Network significantly improves user’s Bitcoin transaction experience, lowers the costs of transactions, and improves the overall Bitcoin Network speeds, it presents a serious challenge when it comes to taxation.

Bitcoin’s taxation problem

Under the US law, the Internal Revenue Service (IRS) considers Bitcoin and other digital currencies ‘intangible property’ and as such, are subject to capital gains taxes. Everywhere else in the world, cryptocurrencies are rightfully regarded as money that can be used as legal tender in exchange for goods and services.

The United Kingdom treats Bitcoin as a foreign currency, while Germany does not subject it to capital gains tax. Even Switzerland, a tax haven, levies various taxes on Bitcoin, including income taxes, wealth taxes, and profit taxes.

Since Bitcoin payments are taxable transactions, it is vital that users accurately track capital gains accrued when they use it. However, there is a serious problem because its transactions are peer-to-peer, meaning that there is no middleman, such as a bank, between the parties involved in the transactions. Governments have always had an easy time regulating, monitoring, and taxing transactions because of middlemen.

With the widespread adoption of cryptocurrencies and the introduction of efficiency platforms such as the Lightning Network, more people are choosing to make regular payments for goods and services with Bitcoin and other cryptocurrencies.

The problem here is that cryptocurrency users are generally reluctant or find it too bothersome to report taxable Bitcoin transactions to tax authorities, more so for small transactions such as buying a cup of coffee or paying for software. Keeping detailed records of every Bitcoin transaction can be exhausting as there are virtually no tools on the market that simplify the process or make it easy to report such events to the taxman.

To the minority of people who care a lot about conforming to their tax obligations have three options: painstakingly keep records of their transactions, risk getting in trouble with the taxman, or avoid using Bitcoin altogether. To most people in this category, the tax burden associated with making regular payments using Bitcoin overshadows the potential benefits.

How Lightning Network makes the situation worse

Cryptocurrencies and tax laws have only one thing in common: most people do not know the first thing about them. From a cultural and worldview perspective, these two subjects are polar opposites.

Bitcoin was created and is largely accepted as a solution to financial control by governments, exploitation by banks, and abuse by corporations. Cypherpunks, who form the majority of individuals who lead the embrace of cryptocurrency, use it to make a political statement against authority. By using Bitcoin, they are happy to escape the rules and regulations that define the traditional financial world.

In October 2019, the Internal Revenue Service, in its attempt to catch up with the users of cryptocurrency, published its first guide on how cryptocurrency holders can calculate taxes owed on their holdings. The agency admits that the world of cryptocurrency ‘has grown more complex over the years.’ As the general public increasingly adopts the digital currency, IRS’s attempts to come up with regulations and guides on how individuals can remit taxes is a game of playing catch up, to say the least.

The Lightning Network makes it easier for ordinary folk to make payments with Bitcoin, but not to keep records of them. In the eyes of many people all over the world, tax laws are a symbol of the excessive and unnecessary regulations imposed by politicians. Technologies such as the Lightning Network are a savior that finally enables them to take advantage of the benefits of decentralization of digital money, transactions with no regulations, and living in a free society rather than under the foot of a central power of the elite.

Is there a possible solution in sight?

Governments all over the world, including the Lawmakers in the US and China, have realized that outrightly banning Bitcoin is pointless. Governments are slow to find ways to bring cryptocurrencies into the tax bracket and presently have to rely on the goodwill of the citizens to keep records of their transactions and to diligently report and pay their taxes.

However, some industry leaders are making reasonable propositions that may just work. For instance, Coin Center is pushing a bill in the US that would exempt Bitcoin transactions less than $600 from capital gains taxes.

The most viable solution to the Bitcoin taxation problem, according to industry experts, is in policy level and not technical. While regulating Bitcoin wallets may seem like a simpler way for governments to make the taxation problem more manageable, a more practical solution would involve exempting more payments from the burden of taxation rather than attempting to regulate all payments across the board.

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Crypto Daily Topic

Solving Blockchain’s Scaling Problem

Blockchain was conceptualized the first time in 2008 with the launch of Bitcoin. However, it took almost a decade to be fully appreciated as an invaluable public ledger with the potential to disrupt virtually every modern industry. That was the year when the price of Bitcoin got close to $19,900 from a low of $978 at the start of the year, and Ethereum went above $850 from just over $8. At its peak value, Bitcoin’s market cap stood at $320 billion – higher than the total value of all M3 UK currency in circulation. This was before the infamous 2018 cryptocurrency crash of January 2018.

Predictably, the massive cryptocurrency explosion was followed by a big crash, from which many cryptocurrencies that had successfully launched ICOs (Initial Coin Offerings) never recovered. During the preceding explosion, blockchain technology was hyped as the most revolutionary since the internet, and many industries started figuring how it could work for them. From transportation and health industries to banking and voting, the promises and claims that the new technology brought may have set people’s expectations a bit too high too fast.

While famous investors, economists, and even finance professionals warned that the rapid rise of the cryptocurrency prices was a bubble that would ultimately burst, a world driven by vague expectations and hunger for profit failed to listen. Most people read the most subtle signs they wanted to see – such as the listing of bitcoin futures by the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) in December 2017 as a stamp of approval that Bitcoin and cryptos, in general, were ripe for investment.

Weaknesses of blockchain come to light

The rise in the popularity of blockchain and the rapid adoption of Bitcoin, Ethereum, and other cryptocurrencies brought blockchain’s most significant problem to light: it is expensive and can barely work on a large scale. When Bitcoin’s price soared to almost $20,000, its network quickly became overloaded, transactions took as long as a day to confirm, and transaction fees shot up to as much as $60 per transaction.

The world may not have been wrong to believe that blockchains presented a massive opportunity for the human race, but it was at this point that many started having doubts about whether Bitcoin was the currency of the future.

The blockchain technology was introduced to the world just at the right time when we were dealing with the aftermath of the 2008 financial crisis. However, in its current state, it cannot deliver on these promises on a global scale because it has one glaring weakness: it just cannot scale.

To see why this is such a concern, it is necessary to understand how blockchain works.

Blockchain is basically a list of ‘blocks’ of ordered data, in the case of cryptocurrency transactions, ‘chained’ together as a linked list. The blocks, once added to the chain, cannot be modified, which means that the list is add-only. There are specific rules that are followed before a block of data is added to the chain known as ‘consensus algorithm.’ In the case of Bitcoin, it is Proof-of-Work (PoW), while Ethereum is presently switching to Proof-of-Stake (PoS).

Due to this nature, blockchain has no single point of failure or control, its data cannot be altered, and the trail of changes made on the platform can be easily audited and verified. However, these benefits do come at a cost because blockchain is slow, and its immutable database has a very high redundancy rate. This is what makes it very expensive to use and virtually impossible to scale to a global scale.

Blockchain’s need to scale

The evolution of the entire blockchain ecosystem has been rapid over the past couple of years. The widespread implementation of blockchain systems for public use has been a significant vote of approval that the world is ready for it. However, the increasing adoption of these systems has brought to light the need for better design or alternatives.

The consequences of the increase in the number of daily transactions on a blockchain network have shown that block difficulty increases, thus increasing the average computational power required to mine a block of transactions. This translates to increased electricity consumption.

Another problem that prevents blockchain from scaling is that an increase in the number of transactions increases the size of the blockchain, making it harder to set up new nodes on the network to help in maintaining the complete blockchain network and to process and verify transactions. Therefore, the systems get not only slower and more expensive, but also unsustainable for such use cases as making regular small payments.

Potential solutions for blockchain scaling

There are numerous real-world uses of blockchain that have shown just how necessary the technology is for the future of humanity. Aside from payment processing and money transfer, it can also be used in monitoring supply chains, digital identification, digital voting, data sharing, tax regulation, and compliance, weapons tracking, and equity trading, among others.

One area that shows great promise and has accelerated the need for blockchain to scale is dApp or distributed apps that run on the blockchain network.

Over the past year, many developments have been proposed to resolve the platform’s scalability problems  – even implemented in some industries. So far, it shows great promise.

Here are some of the most sustainable ideas that blockchain platforms can implement to scale

☑️ Increasing the number of transactions in a block

A blockchain network would scale better when the number of transactions in a block is increased. This can be achieved by either increasing the block size or compressing individual transactions.

Bitcoin’s block size is limited to 1 megabyte. There was a lot of controversy in 2010 through 2015 on whether this size should be altered to accommodate more transactions to help the network scale.

Blockchains can also implement more efficient hashing algorithms that better compress the data to be added to the block. Algorithms that generate shorter signatures would go a long way to reduce the size of the block, and using better data structures to organize transactions may not only reduce the size of the block but also improve the privacy of its content.

☑️ Increasing the frequency in which blocks are added to the chain

The Bitcoin network adds a block of transactions every 10 minutes, while Ethereum does so in about 7 seconds. This duration is a function of the block difficulty level in a Proof-of-Work consensus. Since the frequency in which a new block is added to the chain significantly affects its transaction rate (TPS), reducing this time would significantly increase the network speed and reduce delays.

However, this rate of adding block cannot be arbitrary. Increasing the frequency would mean an increase in the block orphan rate (the rate at which mined blocks are not added to the blockchain due to competition) and an increase in the network bandwidth.

A change of such magnitude would require a hard fork of an existing blockchain platform. Since this is not backward compatible, it would not work for Bitcoin, Ethererum, or other established blockchain systems.

☑️ Implementing alternative communication layers between nodes

There is constant communication between nodes on a blockchain platform depending on the protocol it implements. For instance, in the Bitcoin network, transaction information is sent twice: the first time is in the broadcasting phase of the transaction, and then after the block is mined.

The Lightning Network is an excellent example of a second layer payment protocol that runs on top of the Bitcoin blockchain. It enables faster transaction speeds between nodes by opening a payment channel that commits funding transactions to the underlying layer without broadcasting to it until the final version of the transaction is executed. This is presently touted as the best solution to Bitcoin’s scalability problem.

☑️ Adopting better consensus and verification methods

At the time of writing this post, Ethereum is in the process of switching its consensus mechanism from Proof-of-Work (PoW) to Proof-of-Stake (PoS) to mitigate its scaling problem. Bitcoin uses the oldest yet most difficult to scale PoW. PoS is not only sustainable in power consumption but also results in higher block addition frequency to the blockchain and, ultimately, better scaling platforms.

Other than the blockchain consensus, a blockchain platform can scale better when better storage architecture that saves space is implemented. Blockchain takes up a lot of storage space because each node is required to have the whole blockchain state in order to verify new blocks. Since the size of the block increases with time, the platform would scale better if nodes could only store parts of the chain required to verify current blocks.

Bottom line

Different blockchain platforms have implemented various strategies in an effort to make their platforms scale better. The bottom line, however, remains that blockchain’s scalability problem persists as no solution has proven to be effective without compromising any of the top features that make blockchain a transparent, secure, and truly decentralized ledger system. However, considering how far the world has come in developing this new technology, we remain optimistic that there will come a solution that will finally make a global-wide blockchain system practical and seamless.