In the Lightning Network, inbound liquidity is a precious resource. The Galoy Research team discovered an irregularity and, while attempting to fix it, encountered an entire business model. Their elegant solution transforms a problem into dollars, which is remarkable. This case reads like a detective novel. Let’s dive in.
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Liquidity Leechers and Incoming Liquidity
In the article “Galoy Research: self-balancing fee structures for inbound liquidity”, the company describes the problem and then presents us with the solution. Galoy are the creators of the Bitcoin Beach Wallet Bitcoinist described here† The irregularity the team discovered was this:
“Galoy CEO Nicolas Burtey noted that the onchain hot wallet was running low on a subset of users. These users were consistently sending bitcoin offchain to the Bitcoin Beach Wallet and then withdrawing it onchain.”
The company had to “use submarine swaps to replenish our onchain wallets and reclaim some inbound liquidity.” The point is, “inbound liquidity is a valuable resource on the Lightning Network. The “liquidity leechers” used Bitcoin Beach Wallet as a cheaper alternative to a service like Loop from Lightning Labs.”
How does Loop manage outbound and inbound liquidity?
The service’s official website describes Loops as “the easiest way to manage inbound and outbound liquidity on the Lightning Network”. The service has two sides. On the one hand, “Loop In” allows typical users to “top up” their Lightning wallet when the money runs out. On the other hand, Loop Out is for:
“Sellers, services, and users who primarily receive money through Lightning, Loop Out serves as a bridge, allowing money from the Lightning Network to be sent to “on-chain” destinations such as exchange accounts or cold storage systems.”
Instead of trying to get hold of the people who were “using Bitcoin Beach Wallet as a cheaper alternative to a service like Loop,” Galoy developed a product for them.
BTC price chart for 03/16/2022 on Binance | Source: BTC/USD on TradingView.com
A dynamic fee
Back to the article, the adventure begins. “Nicolas and Galoy data scientist José Rojas Echenique wanted to diagnose the problem and try to find an appropriate solution”. The duo “first looked at historical data to get a better idea of the problem”. Surprisingly, they found that “the price of inbound liquidity is about the same no matter how you get it.”
Here is the product shown:
They then looked for a solution that would charge this roughly comparable market rate for the full range of usage scenarios — including those with Bitcoin Beach Wallet as a loop-out service. The result is a dynamic fee structure (as described in the report) which charges each user a reasonable amount based on how they use the service.
Rather than excluding “those who use Bitcoin Beach Wallet as a loop-out service”, the company has included them. They put a price tag on the service and kept pushing it. How works? the actual report describe this “dynamic rate structure”?
“From a user experience point of view, this approach trades high costs for simplicity. It does not take into account the balancing effects of a user’s past or future transactions, which is why users are overcharged.”
“A smoother dynamic fee formula would take into account a user’s past transactions and charge users less if their current transaction balances their past transactions.”
Continue business as usual
From a problem to a product in three easy steps. Back to the article, Galoy lists the value proposition of their approach:
“By solving the fee issue, Bitcoin banks and other Lightning services can continue their business as usual instead of trying to detect and regulate actors using their liquidity for looping.”
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And to top it off, the company sums up the benefits of the product. “The result? An automated solution for Bitcoin banks, a good user experience for end users and the right rates for everyone.”
Featured image by Jason Dent On Unsplash † Charts by Trading Display