Thesis: Crypto Liberty Banking for Bitcoin

作者:Eric Yakes;编译:Block unicorn

There are good reasons to support the existence of Bitcoin-based banks that issue their own digital cash currency that can be exchanged for Bitcoin. Bitcoin itself cannot be scaled to every financial transaction in the world that is broadcast to everyone and included in the blockchain. There needs to be a secondary payment system that is lighter and more efficient. Similarly, the time spent waiting for a Bitcoin transaction to complete is unrealistic for medium and large purchases.

Bitcoin-based banks will solve these problems. They can operate like banks before state-owned monetization. Different banks can have different policies, some more aggressive and some more conservative. Some can be partial reserves, while others may be 100% Bitcoin-backed. Interest rates may vary. Cash from some banks may be traded at a discount to cash from other banks. ——Hal Finney

Block unicorn note: Hal Finney was one of the early supporters and participants of Bitcoin. He is a computer scientist with extensive knowledge and experience in cryptography, cryptocurrencies, and blockchain technology. Hal Finney was one of the first transaction recipients of Bitcoin and interacted with Satoshi Nakamoto, the creator of Bitcoin. He is very active in the Bitcoin community and has made important contributions to the development and promotion of the technology. Hal Finney passed away in 2014 from ALS (amyotrophic lateral sclerosis). His contributions have had a profound impact on the development of Bitcoin and blockchain technology, and his name is often associated with Bitcoin’s early history and development.

Bitcoin’s future is uncertain. We don’t know how well it will scale, how private it will be, how it will be stored, or even how it will be used for payments. In addition to the progress of protocols and applications, the development of the Bitcoin financial system is likely to have the most significant impact on the value of Bitcoin as an asset, with a wide range of potential outcomes. Consider two hypothetical extremes: in one case, all bitcoins are held in escrow by a third party, and receipts are exchanged between users. In another case, Bitcoin becomes a self-custody peer-to-peer asset for everyone in the world, offering a variety of financial functions.

Both of these extremes are unrealistic, and when mature, the system may end somewhere in the middle. Many will pay a custodian to store their bitcoins, while others won’t. Some will use protocols that can be unilaterally withdrawn, while others will trade rights issued by a third party that represent the underlying Bitcoin.

What is unique in the emerging Bitcoin financial system is the application of cryptography to basic financial functions. There are novel technologies that are being built, and some that have been theorized that will enable previously unseen functionality, resilience, and ultimately spark competition among Bitcoin financial intermediaries. The key to these new technologies is the peer-to-peer (P2P) exchange feature; Bitcoin financial intermediation will certainly exist as a business option, but new direct operations and exchanges will also emerge.

I will analyze the possibility of such a system development, but will deliberately take a tendentious view: I assume a basic premise that the more likely P2P (peer-to-peer) it is, the better. Better means I think financial autonomy is a fundamentally good thing worth pursuing, but better also refers to Bitcoin’s overall stability and neutrality. Trustworthy third parties may emerge based on the convenience offered, but if they (governments, centralized organizations) dominate P2P opponents, the entire system will be threatened.

This article is an extension of my previous article, Bitcoin Banking, which covers the theory of full backup banking and free banking, and applies these systems to technologies such as the Lightning Network (LN) and joint Chaumian minting. I will expand on the analysis of the above, introduce other emerging technologies, and focus on the possible economic characteristics of the concoction of results. The best place to start is to discuss trust.

You just need to trust the community

Few species are as cooperative as humans. We work best with our closest relatives because they are most aligned with our genetic interests, which compete to be passed on to future generations. Evolutionary biologist John Maynard Smith proposed that genes evolve to find a Nash equilibrium when solving strategic problems under competition. This is known as the evolutionary stabilization strategy, where our genes evolve to influence our behavior, and in general, we help our genes to be the most similar replicas.

Within a limited geographical range, the interests of communities tend to be relatively aligned. For example, everyone can agree that they want to be safe. The controversy is over how to approach and at what cost.

Gene agreement varies by geographic location, but geographic agreement does not change by definition. Around the world, the interests of community members are highly aligned. There are many benefits that come with being part of the community.

As individuals gain more from their community, their risk losses also increase. The social risk hypothesis argues that depression is an adaptive, risk-averse response to the threat of being excluded from social relationships, which will have a critical impact on human survival and reproductive success. Humans are likely to be inherently avoidant of social exclusion.

There is no doubt that people are selfish, and their interests are often at odds with those of the community. No amount of evolutionary theory can stop littering, and it can’t stop noisy parties for your own pleasure and disturb your neighbors’ sleep. However, although these examples can cause some social friction, these things, while generally speaking, causing social discomfort, are usually not considered important enough to risk being excluded from society. In contrast, if a community member is caught stealing another person’s car, the social consequences can be much more severe.

In the absence of the cost of community exclusion, moral hazard often arises, as the benefits of a defection that violates a conflict of interest outweigh the benefits of maintaining a long-term net positive contribution. Known as the agency problem, a conflict of interest between the principle and the agent will lead to moral hazard, all else being equal. Community social costs don’t solve the agency problem, but they do alleviate it.

In addition, the community has grown with the advent of the internet. This evolution has made geography no longer a vital feature of community consistency, while enabling communities of common interest to form on a global scale. Global online communities are not the result of genetic or geographic agreement. Rather, they are formed out of common interests. There is a lot of potential for new technologies and financial arrangements to exist among online communities, which is discussed in more detail below.

Where economic agency exists, community trust mitigates moral hazard. The advent of the Internet has enabled new forms of community trust, which in turn can mitigate new types of economic risks.

Community & Values

Community trust can be leveraged in a variety of ways. For hundreds (and possibly thousands of years), informal financial groups have existed as a way to save and borrow, whether it’s savings and credit associations, village savings and loan associations, savings and credit unions, and so on. Today, informal financial groups are the main mechanism for saving and borrowing for those who are disconnected from formal financial institutions.

Community trust is also harnessed through formal financial institutions. As of 2018, there are 85,000 credit unions worldwide with 274 million members. Before the financial crisis, commercial banks made subprime credit loans five times more than credit unions, and during the crisis, commercial banks were 2.5 times more likely to fail. Their public trust is higher, and small businesses are 80% less dissatisfied with credit unions than big banks.

According to the FDIC’s 2020 Community Banking Report, community banks are less likely to close their doors, have performed better since the financial crisis, are the main providers of funding for local businesses (especially commercial real estate, small businesses, and agricultural loans), and are more widespread in rural areas, where community banks are local in nature.

As brick-and-mortar banks in many rural areas become uneconomical or not open enough, people are looking for digital solutions to bank the unbanked. Bitcoin is an emerging digital currency system with features that can facilitate the establishment and development of both informal and formal financial groups. As a monetary asset, Bitcoin is unique in that individuals are able to self-custody, which makes participation in the banking system an option rather than a necessity.

In addition, the fact that Bitcoin is the digital native currency enables online-connected global populations to voluntarily form financial groups, and Bitcoin’s programmability allows these groups to innovate new trust mechanisms. With the help of this technology, community-based financial groups can be formed without geographical restrictions. By utilizing Bitcoin for transactions and various financial functions, mutual benefits can be achieved between geographically dispersed communities.

Bitcoin’s technical characteristics allow it to be adopted voluntarily in geographically widely distributed communities, and novel forms of organization are emerging that have the potential to spawn new financial systems and economic values.

Fedimint is a protocol that integrates four main technologies:

1. Federations: These are a group of individuals who own computers and are able to provide their own storage and processing power to their communities. Their computers have the same software, which allows them to pass information to each other. The federation is made up of a group of leaders, known as “guardians,” who generate and control multisig addresses for bitcoin and have software capable of communicating with the Fedimint protocol. When users want to join the federation, they take advantage of the federation’s storage, processing power, and trustworthiness. This allows them to use any app offered by the Guardian. The main application will be Chaumian eCash (as defined below), but theoretically, it can be anything, and probably primarily a financial application. Federated technology has many things to offer its users, but its primary value proposition is to enable Guardians to faithfully enforce the protocol on behalf of their users.

2. Multi-sig: Bitcoin is stored in a multisig address and is controlled by the guardians of the Federation. To send a Bitcoin transaction, the address needs to reach a certain number of signatures. For example, a 3 in 4 multisig has 4 possible keys, but at least three keys are required to send Bitcoin.

3. Chaumian eCash: A private representation of value that can be traded as a quasi-bearer note. It utilizes a cryptographic construct called “blind signature”: the party issuing the eCash (in this case, the federation) does not know the identity of the recipient (user) of the eCash, but any third party can identify that the “signature” on the eCash comes from that federation. This enables the federation to issue eCash to users who deposit bitcoins into multisig addresses in the federation. Users save eCash on their devices (and back up to the federation if they lose their device), making it a trust-dependent digital bearer note. The eCash created by the Guardian does not have a public blockchain, it is simply kept in the memory of the user’s computer, such as a mobile phone, similar to physical cash, and can also be backed up in case it is lost. This eCash scheme provides a payment method that maintains the censorship resistance of the underlying Bitcoin while increasing privacy, but it is prone to inflation if the vast majority of Fedimint Guardians decide to maliciously and covertly increase the supply.

4. Lightning Network: The Lightning Network (“LN”) can be ideally used to forward payments between federations through Lightning Gateways (discussed below). This creates the ability to instantly exchange eCash (cash digital currency) for Bitcoin and has several implications. Importantly, it increases the fungibility between various federally issued eCash, reducing the incentive for many people to join a federation. The increased fungibility between federated eCash and the optimization of community trust fundamentally incentivize systemic decentralization.

The combination of these technologies forms a set of rules that users of Fedimint software must follow, which defines the Fedimint protocol. As an open-source protocol that anyone can participate in, the ecosystem includes the following participants:

Users: Individuals who have applications capable of running Fedimint and possibly also Bitcoin and the Lightning Network (LN). They send bitcoins to a federated multisig address in exchange for eCash. They can send eCash or the Lightning Network between any apps connected to their wallets, subject only to whether the balance of eCash/Lightning is sufficient and whether others accept eCash/Lightning.

Guardians: Individuals selected by the community to establish nodes that can communicate with Bitcoin, LN, and Fedimint. They form a federation, manage hardware, control bitcoins in multisig addresses, and issue eCash. They can also act as a Lightning Gateway Provider, but this requires specialization (discussed below), so another entity called a Lightning Service Provider (LSP) may perform this function.

Lightning Gateways: Lightning node liquidity providers using Fedimint. Readers can think of it as a lightning-to-eCash exchange connected to Fedimint, and they integrate with Fedimint users, as marketplace makers, ready to send lightning payments and receive lightning payments for a certain spread. Any federated user can do this, but running a well-connected, high-capacity Lightning node requires specialization, so this feature may be provided by an extended LSP. If a user wants to send “eCash” to another Fedimint user, they send eCash to a gateway that then forwards the equivalent Lightning payment to another Fedimint gateway, which then sends the eCash to the receiving user. eCash cannot leave one Fedimint, it can only be exchanged with Bitcoin or Bitcoin on LN, which can then be received by other Fedimint’s gateways and converted back to eCash in a new domain. However, users can integrate with multiple federations and exchange eCash between users of those federations.

Modules: Applications within the Fedimint protocol. For a specific federation of users to use a module, the federation needs to support the module. Fedimints will launch three standard modules: Bitcoin, eCash, and Lightning Adapters. Examples of potential modules in the future include smart contract platforms and syndicated marketplaces. Any federation can choose to support any module. Some federations will have high-performance infrastructure that will support the applications needed (e.g., exchanges), while others will have the infrastructure to support the most basic functions of sending eCash and lightning payments. Users can integrate into as many Fedimints as they want to use and choose the modules they want.

To sum up, the Guardians form a federation, and users can choose to join by downloading software that supports Bitcoin, the Lightning Network, and eCash. The federation that users choose to integrate will determine the features they are able to access. Some federations will be simple community federations with limited default modules to enable payments. Some federations will have high-performance infrastructure that can support more challenging, potentially commercial-scale applications. Users can host funds in their communities while connecting to a commercial-scale federation to use more business-minded applications. I expect some federations to form in geographic communities, and some commercial-scale federations to support large communities across borders. The system leverages Bitcoin, the Lightning Network, and eCash technology to provide a satisfying consumer experience through an app and community hosting.

Fedimint is an innovative solution for basic hosting functions. The traditional banking system has had little innovation, at least functionally, in custody operations in recent history. As the most basic function of a bank, custody operations have evolved to improve the security measures of digital banking. Federal technology provides a new frontier of innovation for hosting operations. Federated custody operations have a lot of potential for growth and can refactor the nature of the organization to better align with the interests of stakeholders. Centralized financial intermediaries must now compete, not only with self-custody systems, but also with federal systems.

Fedimint combines federal infrastructure with Chaumian eCash, the Lightning Network, and potentially further integrated applications to provide technology that can support a variety of communities, whether established or new.

eCash

Another implementation of eCash (which can be understood as electronic cash or digital cash) is the open-source project Cashu - a non-federal version of Chaumian eCash. Cashu is similar to fedimint in that it issues eCash (digital cash), but the difference is that it is not a federation of a group of servers, but a single server. While more trust is required in the absence of federation, this system does not require a consensus algorithm, which reduces transaction latency. In addition, Cashu only uses LN (Lightning Network) and the federated method does not yet exist, while fedimint uses both on-chain Bitcoin and LN. As a result, Cashu’s use cases and requirements as a protocol may differ from fedimint.

Notably, Calle, the creator of Cashu, proposed a proof-of-liability scheme that was considered likely to be widely implemented in the eCash system. Since the ownership of eCash is intentionally blind, auditing the minted supply of eCash is inherently challenging. This topic will be discussed in more detail later.

Both Fedimint and Cashu are very new, and this discussion is a forward-looking and theoretical discussion of the potential of this ecosystem. In particular, the integration of LN (Lightning Network) through an LSP (Lightning Network Service Provider) could lay the foundation for a native Bitcoin banking system. My first article on this topic covered academic theory and ended with a practical discussion. The remainder of this article will expand on this perspective by discussing what is likely to emerge in this ecosystem.

Cashu is a standalone eCash protocol optimized for simplicity and speed. The creators of Cashu have come up with a novel scheme that allows the minted eCash supply to be audited while still protecting privacy.

Currency trade-offs require different payment methods

So far, we’ve defined various protocols (such as eCash and LN) that appear to implement different forms of money than Bitcoin. Theoretically, market participants converge on a monetary standard. In an ideal world, there would only be one form of money. However, in history, this has never happened, why?

While I’m not sure if this is conceptually complementary, in my book I define three main reasons why multiple forms of money exist:

**1. Opaque information: Many different forms of original money were used at the same time, because neighboring societies were not economically integrated and knew nothing about other forms of money. Awareness is important because it enables individuals to verify the validity of money. Because people simply don’t understand the currencies of other societies, they can’t verify them and have difficulty accepting them for trading. As societies converge on a global scale, the Internet has created global networks, and verification problems have been largely mitigated. But it’s not perfect. Not everyone is connected to the internet. The level of awareness of a form of currency and the ease of verification are necessary for widespread adoption.

**2. Sovereignty Enforcement: Today’s users don’t choose a currency, but a government. If the currency is chosen in the market and not imposed on society for political purposes, the currency chosen will be different from the fiat currency that is enforced today. It is likely that we are witnessing the early stages of the decline of this system, but any transition requires an alternative that is practical enough and decentralized to eliminate the possibility of coercion.

**3. Trade-offs in the role of money: Different forms of money retain different characteristics that make them more suitable for some forms of trade than others. As a result, we often see dual monetary systems in history, such as cattle and salt, or gold and silver. A similar situation in modern times can be real estate and the US dollar, where real estate is used to store value and US dollars are used for transactions.

As a technological innovation, Bitcoin greatly alleviates these limitations, but some argue that it is not a panacea for all problems. The Bitcoin base layer network alone (before any scaling mechanism) is able to store value well, but there are two main problems:

1. Transaction throughput: The transaction throughput of Bitcoin’s base layer network is not enough to support global payments.

2. Privacy: Bitcoin’s default setting is not private, as transactions are recorded on a public ledger. It takes a lot of effort to increase the privacy of Bitcoin transactions.

The Lightning Network is an attempt to solve the transaction throughput problem, although it also brings its own problems. This network is gaining adoption and could become the global payment network needed for Bitcoin payments, or at least a significant part of this eventual network. Although sending a time-locked and fully collateralized Bitcoin transaction via LN (Lightning Network) is very similar to sending a direct Bitcoin transaction, it does have different characteristics compared to an on-chain Bitcoin transaction. The Lightning Network is faster, but requires channel capacity constraints to receive payments.

It’s less secure because the participating network requires storing bitcoins in hot wallets, not to mention that lightning is newer than a layer of bitcoins, and potentially more complex protocol risks are unpredictable. To alleviate trust requirements with channel partners, forcing a channel to close delays your ability to receive on-chain Bitcoin. For these reasons alone, one could argue that the economic properties of lightning payments are fundamentally different from on-chain Bitcoin payments, and if one accepts this view, lightning can be considered a different monetary medium than Bitcoin.

Although interesting in theory, this may only be a semantic difference. In fact, market participants seem to think that lightning is interchangeable with Bitcoin, which is probably the most important.

Similarly, privacy concerns can be addressed in a variety of ways. eCash is one of those ways that offers almost perfect privacy but comes at some cost to auditability. One has to trust that the issuer of eCash will not spam it (more on this later). However, it does offer the same anonymity and convenience as physical cash, and perhaps to a greater extent because it is in digital form. For similar theoretical reasons, this can also be defined as a different monetary medium – although, again, we’ll see if it has any practical relevance in practice.

It is important to distinguish between the medium of exchange and the means of payment – as summarized by Young:

"The former (a) refers to the collection of assets that people in the economy often use to exchange goods and services (a concept of ‘what’), while the latter (b) is a method of facilitating the transfer of money from one party to another (a concept of ‘how’). It suggests that money should be defined separately as a ‘medium of exchange’ and not as a ‘means of payment’. With such a distinction, one can consistently explain why money, demand deposits, and smart cards are money (because they are the medium of exchange) and why checks, money orders, or debit and credit cards are not money (because they are only means of payment and not a medium of exchange). "

The Lightning Network and eCash can also be understood as different means of payment, rather than different monetary mediums. One can argue that eCash is a different kind of asset whose value comes from the demand of market participants for its unique characteristics. However, its value is ultimately settled on the Bitcoin blockchain. Whether eCash is considered a separate monetary asset or means of payment will depend on how the system operates as it matures. For example, if it is decentralized, then its value as an asset will depend on the trust in the issuing union, while if it is a 100% reserve alliance, then its value will depend on the purchasing power of Bitcoin. Similarly, even if the U.S. dollar is partially backed by gold, it is not considered gold, and a 100% reserve gold receipt is considered closely interchangeable with the possession of actual gold (except for political considerations). Since the Lightning Network has a similar economic model to owning Bitcoin, and users and the market seem to see it as such, it could most likely be described as a means of payment for Bitcoin.

Theoretical and semantic issues aside, the systems described so far will exist at the intersection of three or four protocols: Bitcoin, the Lightning Network, Fedimint, and/or Cashu. The integration of these protocols allows the economy to have decentralized security for Bitcoin as a base layer monetary asset, privacy and transaction throughput for eCash as a medium of exchange, and a unilateral exit of the LN (Lightning Network) channel as a technology to facilitate this means of payment.

Various protocols that interact with Bitcoin are forming new means of payment. Whether or not these protocols eventually become independent medium of exchange will become apparent as the system matures.

Bitcoin Native Money Market

The monetary system described so far has had a wide-ranging impact on the emergence of digital-native markets. In a previous article, Nik Bhatia argued that the Lightning Network is a native instance of Bitcoin for the risk-free rate. Despite being similar to the base interest rate of the fiat currency system, the nature of the Lightning Network is fundamentally different in that there is no (economic) counterparty risk associated with earning proceeds on Bitcoin through routing fees and liquidity leasing. Bhatia further extended this theory to the lending risk curve with counterparty risk:

Figure 1 - A novel interest rate term structure for the Bitcoin financial system

Through this lens, we can see the emergence of LN (Lightning Network) node operators as the emergence of Bitcoin-native decentralized financial services/infrastructure providers. This is most likely a mix of self-hosted and managed services. If a custodian service provider evolves to provide banking functions, then it could be a mix of full reserve banks and partial reserve banks. If LN (Lightning Network) node operators are in the lending business, the market will determine what system emerges in the end.

What is certain is that a currency market is being formed inside Bitcoin, in which market participants voluntarily participate in order to gain economic benefits. In the U.S. financial system, the money market accounts for about one-third of the value of all credit markets.

Broadly speaking, the money market is a market for short-term cash borrowing. In contrast to capital markets, the latter are used for long-term borrowing, equity investments, and derivatives. Both involve contracts, and their contractual nature is where they are distinguished (although, again, this distinction is somewhat subjective and we should not get bogged down in semantics). Capital markets include a wider range of assets, span more types of contract terms, and have longer time horizons. Since non-Bitcoin assets have not yet emerged within the Bitcoin ecosystem, capital markets have not yet formed on a large scale. However, with LN (Lightning Network), the money market is forming.

If the consortium that issues eCash emerges on scale, then there will also be various eCash markets that compete for fungibility with their underlying Bitcoin. The market will dictate this interchangeability, and the main players will be Lightning Gateways. They will be ready to accept eCash and forward the equivalent Lightning Network payment to the recipient of the transaction. In doing so, they will distinguish between the various eCash issued by the Federation. In return, they will earn the spread on each trade, forming a currency market. Therefore, lightning-to-eCash market makers can earn the spread by pricing risk, which we can assume is priced as follows:

Figure 2 - Market transactions between the Lightning Gateway and the Federal, which can be conceived as a new source of economic benefits for the term structure of interest rates

In other words, if the federated Chaumian eCash finds market adaptability, the Bitcoin ecosystem will witness the emergence of a new kind of money market. The market will form transactions between Bitcoin or the Lightning Network and various forms of eCash issued by the Consortium. An LSP (Lightning Service Provider) can act as a broker to earn competitive spreads between eCash and Lightning Network marketplace transactions.

Ultimately, the value of these markets will derive from the adoption of the means of exchange they represent. This creates a virtuous cycle of growth. The money market provides interest rates and attracts capital. Investments in these markets increase the usefulness of the features they support, which in turn should increase the adoption of the technology.

Bitcoin’s native money market is emerging next to the protocols it supports. Over time, these markets will attract investment and create a virtuous cycle of adoption.

Risks of an Alliance eCash System

eCash is designed to be exchanged for the Lightning Network or Bitcoin by issuing a consortium, and Lightning gateways are used to forward payments between federations, theoretically making various forms of eCash interchangeable. The system can be visualized in the following ways:

Figure 3 - A simplified visualization of the interaction between user wallets, federated Chaumian mints, and LN gateways (Chaumian refers to an anonymity and privacy protocol and technology first proposed by David Chaum in 1983 to protect the privacy of digital transactions. ）。

1. Wallet A supports Bitcoin, the Lightning Network, and Consortium A’s eCash, which sends Bitcoin to the consortium in its own community.

2. In exchange, the consortium sends eCash to wallet A without knowing the identity of the owner. Any member of Affiliate A can easily receive eCash payments from Wallet A. However, if Wallet A wants to use eCash to send a payment to someone in Affiliate B, they need to utilize a lightning gateway.

3. The Lightning Gateway acts as a marketplace maker, ready to send/receive any Bitcoin/Lightning Network/eCash and earn the difference on every transaction. So, when wallet A sends it eCash, the Lightning gateway will accept it and send the Bitcoin/Lightning to another Lightning gateway connected to Union B, where wallet B is located.

4. Wallet B can then accept this amount in Bitcoin or the Lightning Network, or if desired, exchange it for BTC from Alliance B.

The trust needs of users for trusts in the federation to which they belong are more dependent on professional administrators and the ability to conduct private transactions. Self-custody can be more complicated for the average individual, and the risk of losing the private key is permanent due to the finality of Bitcoin maintaining settlement. As a result, individuals may turn the risk of trusting the federation of trading communities into the benefit of reducing the risk of Bitcoin loss and gaining privacy in transactions.

However, users don’t just trust the federation to which they belong not to lose or steal Bitcoin. Users also trust that the Federation will not issue more eCash than the Bitcoin they have received. Since there is no cryptographic link between eCash and the bitcoins received, the federation can unilaterally issue eCash. Privacy benefits also mean that supply is difficult to audit with traditional strategies. This leads to the risk of federal depreciation of eCash, so what can prevent this from happening?

If a community trusts the administrators of the federation not to steal their bitcoins, then they also trust that the administrators will not devalue it. Malicious managers may simply collude to steal Bitcoin instead of devaluing eCash. However, managers can also take advantage of supposedly trustworthy escrow schemes to slowly devalue eCash (more on that later). Still, this is a very large cost for a community’s interest, and these incentives do make community hosting a less trustworthy system compared to third-party hosting.

On the other hand, what if, on the other hand, a community’s interests coincide with the depreciation of its eCash? Theoretically, Federation A could convene the community, announce that it would devalue its eCash in exchange for goods and services with Federation B, and distribute the goods obtained equally among community members. The community agrees because they like to trade priceless treasures for something of value. However, if such a system emerges on a large scale, it is likely that there will be some checks and balances to reduce this perverse incentive. To understand this, we can look back in history.

There is indeed an undue incentive to devalue eCash (independently), but natural market incentives can mitigate this risk.

Bitcoin & Free Bank

The free banking system, which has been discussed in detail in previous works, can be used as a benchmark for assessing the competitive dynamics of custodian systems. Applying this understanding to the federated eCash system provides a framework for understanding the potential of this technology.

In a free banking system, banks are free to issue paper money, and the market decides whether these notes have value or not. If a bank issues more banknotes than its reserves, then it is at risk of bankruptcy. Applying this risk to a competitive market limits the extent to which banknotes are issued across the system. Through the issuance of paper money, circulating credit can only be expanded to a certain extent, otherwise a systemic bank run is inevitable. However, it is in the bank’s own interest not only to maintain solvency within the system, but also to the stakeholders of the system. Rational customers would not use banks that they suspect bankrupt, because that would effectively mean that as unsecured creditors of an institution that has already gone bankrupt, they themselves are bankrupt. In reality, however, most customers seem to assume that the bank is solvent, whether or not this is often or ever accurate.

In a free banking system, there is a greater degree of information asymmetry, which has historically led to bank failures, and customers have not suspected the problem until it is too late. As a result, those who take the time or can naturally get more bank-related information, act as caretakers of the system. There are three main groups that limit the issuance of banknotes to no greater than the natural issuance of banks, and this is because of their perception of self-interest:

Competitors: Competition between banks limits the amount of paper money that one bank can create more than any other bank. Through the practice of scramble for banknotes, more conservative banks will use their capital to acquire rival banknotes that are suspected to have been highly issued, and then cash them out in one go, potentially pushing them into bankruptcy. Competitors can acquire competitors at a low price to gain market share in a conservative way. This practice was more common in the early days of the banking system and decreased as the system matured and clearing houses (discussed later) appeared.

Brokers: Those groups that have access to more bank-specific information will speculate on the bank’s solvency and make a profit through carry trades. They would buy notes that were not widely accepted at a discounted price and then cash them out at the issuing bank at the full convertible value of the gold, making a profit. They are able to do so because they take the time to get specific information about the bank they intend to broker. This practice broadens the acceptance of paper money, imposes limits on the risk banks can take, and increases the transparency of information in the system. These categories of brokers were more prevalent in the early days of the system. Once the system reaches maturity, the clearing house will offer similar capabilities.

Clearing House: As the system matured, clearing houses emerged to facilitate the broker’s functionality and increase the transparency of information in the system. This constant process of cashing out gross banknotes is complex and operationally intensive, so banks need a way to netting their repayments, thereby ultimately reducing the operational burden on the system by settling their debts in one place (or at least less). This led to the establishment of clearing houses, where all banks would settle their responsibilities and only settle the net difference in their accounts. Centralized settlement of debt puts clearing houses at the center of the system, and they often develop more functions such as: credit monitoring, agreements to facilitate reserve ratios, interest rates, exchange rates, and fee schedules, and assisting banks (borrowing or acquisition intermediaries) in times of crisis. Membership in the clearing house is based on reputation, and only institutions that meet certain criteria can join the “club”. This is important because trust is intrinsic to the system, and reputation is essential to maintaining it.

In light of this, let’s go back to the issue mentioned earlier: the Confederation may have an incentive to devalue their electronic cash and trade it with valuable goods and services from another Confederation. In short, this is a classic “tragedy of the commons”, where the commons is trust, i.e. whether the electronic cash of one federation is interchangeable with the electronic cash of another federation. In terms of independence, this incentive appears to pose a fatal threat to the success of the system, but when considering the emerging parties and the checks and balances they impose on the system, natural market dynamics may exist to mitigate this risk. Several participants in a federal electronic cash system like Fedimint can provide these capabilities:

Federal: Most federals exist only for hosting and payments, but some federals exist to provide commercial-scale functionality. We can imagine that we can’t everyone have their own path to the city. The trusteeship will eventually develop into community streets, city roads, and highways. Fedimint (and LN Gateway) provides the architecture and functionality to extend hosting into a set of street and highway networks. Confederations will compete to build trust in the broader ecosystem. For streets, this will be a community-level trust, while for highways, it will be a more system-level trust, and the reputation of a large-scale federation will be critical to its success.

Lightning Gateway: For a Lightning gateway to integrate and forward federated payments, it must hold the eCash balance of that federation, i.e., accept eCash and forward Bitcoin via lightning to another federation. This will not be an indiscriminate process. It acts as a marketplace for individual federations only if the gateway believes and has the potential to verify the solvency of that federation. Gateways may be concerned if they notice that eCash balances are increasing, while on-chain data shows that Bitcoin balances are remaining relatively stable. Terminating their services could be fatal to the federal’s trading utility. As a result, the federation that holds eCash will only work with the gateway if it feels comfortable, and the Lightning gateway will oversee the interchangeability between the various federation-issued eCash in its own interest.

eCash Brokers: It is likely that there will be a class of brokers that function similarly to Lightning gateways, but instead of forwarding lightning payments, they will only exchange eCash from Federation A with eCash from Federation B. By acting as a direct market manufacturer, they will replace the Lightning Network with a centralized account-based ledger for transaction throughput. The broker will constantly monitor and determine which eCash they want to hold their balance on, as well as which eCash they want to avoid or buy at a discount. This market-making activity would provide another check on the fungibility of eCash and prevent the Federium from arbitrarily depreciating its eCash value.

Proof of reserves: Companies that build technology to monitor institutional reserves can also play a key role in effectively acting as a federal credit regulator. Their appearance can provide some form of validation, though not a perfect form. They can certainly monitor multisig addresses (assets) on the chain, but liabilities will be more challenging. The Federation doesn’t know who owns the eCash it issues but it knows how much it has. A federation can provide third-party credit regulator access and details of its issuance and redemption history, which is sufficient to provide sufficient information to assume full reserves or strong solvency (as described below). As a result, credit regulation and the reputation of a large federation are essential to gain integration across the ecosystem. However, this does not eliminate the risk that a federal is issuing out-of-band liabilities, which requires a third-party audit. For this reason, it is likely that the reserve proof firm will work with or provide services to an audit firm to increase the assurance of this risk. Web-of-Stakes (33) is an emerging concept of the Civ Kit protocol that can mitigate this risk in specific applications.

Solvency speculators: A class of hedge fund-like risk-takers may emerge who will bet on the solvency of various eCash notes. This would only exist in commercial organizations where funds can perform redemption attacks and hope to make a profit. This would be similar to a bill duel between competitors, in which the fund would not benefit from gaining a competitor’s market share, but would instead profit from a short position in the value of that federation. This category may be the last to emerge, as its existence will depend on the establishment of a mature liquid capital market within the system.

Importantly, the digital nature of this system will allow participants to quickly and cheaply profit from currency devaluations. By eliminating the possibility of devaluation as a long-term business model, and perhaps even unprofitable in the short term, participants in this system are incentivized to act in a prudent manner. Never before in history has there been a financial system with such incentives.

If such a system emerges at scale, we are likely to see the consolidation of these functions between various service providers. I anticipate that LSPs can not only act as lightning gateways, but also adopt eCash brokerage services and potentially acquire or leverage voucher companies and protocols. Just as brokerage and credit monitoring functions are integrated into clearing houses in traditional freebank systems, I also expect the integration of these functions in community eCash systems to emerge. However, all this assumes that such a system will indeed be able to emerge on a scale, which will undoubtedly take a long time or not happen at all. Fortunately, technological solutions have the potential to emerge and mitigate the risk of eCash depreciation in the short term.

Free-market incentives align the interests of agents and consumers with existing trust. This alignment of interests increases as the system matures, as the value of the system attracts the participation of market participants.

Proof of Liability Scheme of eCash Minting Institutions

The federated escrow system reduces the risk of misappropriation of user funds by custodians to a certain extent. It also reduces the risk for mints to reduce the supply of electronic cash. Free market systems further reduce the incentive to reduce the value of electronic cash, but for free market systems to function most efficiently, information needs to be as transparent as possible. Ways to improve the transparency of information on unpaid electronic cash by electronic cash mints are essential for efficient markets. The more transparent the information of the mint, the more auditable it will be. But there is also a trade-off, higher auditability may reduce the privacy of e-cash, which is the purpose of e-cash.

Calle, the developer of the Cashu protocol, has proposed a Proof of Liability (“PoL”) scheme for electronic cash mints that aims to increase the transparency of electronic cash supply issuance without compromising the privacy benefits of electronic cash in most cases. This can be achieved by implementing auditability at the system level while allowing participants to maintain privacy at the individual level. The system requires three main voluntary actions by mints:

1. In order to publicly commit to periodically replace its electronic cash private key within a predetermined period of time (“Period”). This allows all electronic cash in circulation to circulate from the old period of time to the current period of time.

2. Generate a publicly audited list of all issued e-cash tokens in the form of a certificate of mintage.

3. Generate a publicly audited list of all cashed e-cash tokens in the form of a burn certificate.

The maintenance system for these attributes enables users of electronic cash issuers to verifiably detect whether the issuer has issued unsupported electronic cash in the past period. This effectively sets an expiration date for the user’s e-cash, forcing the user to refresh their e-cash to a recent period of time. The expiration of e-cash forces users (through automation in their wallet software) to participate in the behavior, ultimately forcing issuers to report past e-cash issuances and redemptions. This is somewhat similar to simulating the risk of a cyclical run on an electronic cash issuer. In Calle’s words:

In a nutshell, constantly changing epochs is like simulating a regular “run risk”, allowing users to look at previous epochs and check if the issuer has made any tampering in past reports. ”（37）

Keep in mind that the goal of this scheme is to best ensure that the assets of a certain issuer (BTC/LN) are greater than or equal to its liabilities (electronic cash). The expiration date of e-cash forces a refresh of all user e-cash in each time period. Therefore, if an issuer keeps track of all the e-cash it has issued, all the e-cash that has been burned, and is forced to refresh the outstanding e-cash amount every month, the user can publicly verify the data on the total e-cash supply that existed during that time. This solution can look like this:

Figure 4 - A proof-of-liability scheme used to increase the transparency of eCash issuance, which typically does not reduce the privacy benefits of eCash. Calle

There are two ways an issuer can try spoofing, and in each of them it can be detected:

1. Reduce its total number of eCash issued by issuing as few blind signatures as possible. Users can detect this and when looking at the publicly available blind signature report, they find that their own eCash blind signatures are not included. Even a single user can reveal that the issuer is falsely reporting its eCash issuance. However, it is important to note that by revealing the issuer, users must waive the privacy guarantees of their eCash. However, LN’s privacy is still strong, and if not this system, it’s still far superior to account-based ledger systems.

2. Increase its total redemption amount by creating a false burn certificate. Issuers can create a wallet, spend unsupported eCash, and report it. However, if a user can provide a set of tokens whose total value exceeds the reported outstanding balance, they can prove that the issuer is cheating. This approach is not perfect, and the issuer can still escape depreciation in the short term, but in the long run, a deceptive issuer is probably destined to be discovered.

Indeed, for any kind of eCash depreciation audit, there is no certainty that a fraudulent issuer will be caught immediately. But what is certain is that the probability of catching a fraudulent issuer increases over time, which is a major innovation. Rational issuers may avoid devaluation because they know that the business model is not sustainable without getting caught and risking a run. This phenomenon is further exacerbated by digitized ticket duels (already described). Just knowing this risk may serve as a deterrent mechanism to prevent eCash from depreciating.

However, this system requires voluntary action by issuers, as well as voluntary requests by users to participate in the issuance of these standards. Wallets need to employ the necessary technology to implement such a best practice. Given the need for users to reduce privacy to uncover fraudulent issuers, I anticipate the emergence of for-profit consumer protection services that establish wallets and constantly check issuers for any malicious or negligent behavior and actively report them. Consumer protection authorities will be able to accept the price of reduced privacy to verify issuers’ eCash issuances. Unlike issuer participants, who utilize technology to shoulder the burden of checking for devaluations, centralized providers can save on the financial expense of this function and provide standard approval for good issuers. For example, a proof-of-reserve company like Hoseki can evolve to offer this kind of functionality. Similarly, if we look at the issuing agency as a restaurant, there will be Michelin-starred reviewers who are constantly and unknowingly eating at these restaurants to decide whether they have been awarded a Michelin star or complained of poor quality.

Cryptography and clever incentive schemes are removing trust from the underlying economic agency problem. **

Decentralized systematization discourages government intervention

Will such a system end up being centralised and controlled by the government, like all banking systems in history? I don’t think that’s likely. If a community hosting model emerges, it is likely to be highly decentralized at the system level. If there were 1 billion users, with an average of 100 members per federation, that would be equal to 10 million communities spread across the globe. In addition, a commercial-scale federation can also exist, for example, as 70 multisig in 100, with signatories geographically distributed across the globe. Since any participant can join any federation in the world, the competition between federations will be fierce between the most trustworthy federations. There will be natural fragmentation not only for cultural, technological and geographical reasons, but also for a high degree of competition. Still, there is a risk of government regulation until the system reaches this scale or establishes this dynamic.

The political fallout of clearing houses and the sustainability of large-scale self-custody are critical to a permissionless financial system native to Bitcoin. Being able to actually operate while maintaining Bitcoin self-custody is the main difference between the Bitcoin Standard system and the Gold Standard system. Gold was not an effective means of payment, so custodian services and paper money became necessary, paving the way for the decentralization of the preparation banking sector, which eventually politics took control of the reserves and eventually removed them. Bitcoin is different. As more and more tools provide individuals with the opportunity to operate in a self-custody manner, it will be possible for individuals to conduct their economic activities without entrusting their bitcoins to a custody provider. It seems that this unique property of Bitcoin will eventually prevent the emergence of similar central banks and fiat currency systems.

Finally, the Fedimint protocol has been designed to accommodate a specific regulatory domain, where guardians regulate assets for the benefit of friends, family, and the community, with no profit motive. If a federation satisfies these characteristics, financial regulations are exempt in many modern jurisdictions, but not in all. Of course, regulations can change. In the systems described so far, commercial-grade federal may risk regulatory enforcement depending on the jurisdiction. Thus, the location of the Federation’s existence, as well as the functions it performs, will materially affect the financial applications it provides and the scale at which those applications are provided. One positive aspect of this situation is that regulations are likely to act as a decentralization across the federal level.

Federation is a cryptographically and economically-based innovation that fundamentally incentivizes the decentralization of custody, and decentralized systems are essential to prevent political control.

The potential of the free market

The system described so far assumes that in the future, eCash will become exchangeable enough for widespread adoption as a monetary asset within the federal system. Why is this happening when Bitcoin and Lightning themselves have solved so many problems? I think there are three main reasons why eCash is valuable to the Bitcoin ecosystem:

Privacy: The Lightning Network improves the privacy of Bitcoin, but eCash offers almost the best privacy. Just like today’s dollar cash system, eCash can also provide true digital cash privacy. Of course, the physical system can be exploited by printing the private key on paper and then verifying the amount through a QR code. Opendime is an example of this, which can be traded like cash. In terms of the privacy it actually provides, eCash can be said to be superior to this physical system because it maintains the selectivity of digital payments.

Settlement certainty: eCash is typically stored on the user’s mobile device and can be backed up to federation via sharding. The process of sharding is to split the eCash mnemonic phrase into fragments and send them to the administrator of the federation for storage, so that in case of loss, the administrator can combine these fragments together and return them to the user. However, if the thief spends eCash before performing the backup process with the administrator, then this may not prevent the thief from stealing the asset.

Capacity limitations: The Lightning Network is limited by capacity requirements, which encourages a certain degree of centralization within the network. eCash does not have this feature. If the Lightning Network continues to be plagued by inbound capacity limitations, eCash could become a viable alternative to payments.

Are these advantages strong enough to justify the potential risk of inflation, or enough to gain market adoption? Perhaps not. An important factor to consider is that the system competes with self-custody to a much lesser extent than with centralized third-party escrow operations and their associated consumer applications, which are generally easier to use. Centralized systems not only have greater moral hazard, but also the risk of inflation. 2022 was a year in which the world recognized that the assets that existed on exchanges and were said to be owned by depositors did not actually exist. This is known as “Bitcoin on paper” and can be understood as the fact that these exchanges actually reduce the supply through an accounting ledger that is not fully secured by Bitcoin, as long as these balances are considered genuine. In any case, the real Bitcoin supply is not affected. If a centralized ledger is trusted for escrow, there is always a risk of bitcoin on paper and inflation there. So, the question is: would you rather have the incentives for inflation exist in a relatively more decentralized global community model with strong incentives to inhibit, or in major centralized exchanges with strong moral hazard incentives?

Still, will the market voluntarily adopt eCash, or will Bitcoin and Lightning be good enough? Again, maybe not. Please take into account that LN (Lightning Network) is a fundamental part of the federated eCash system. The use of eCash is optional. Theoretically, you can host in a consortium and then only trade in the Lightning Network. A consortium can also be an LSP (Lightning Network Service Provider) that can issue eCash and immediately convert it into the Lightning Network for users to use, or simply not issue eCash. Protocols like fedimint may naturally fit into a community-based LSP model. However, this could lead to a more centralized system, as capacity constraints and financial regulations can limit the consortium’s ability to grow in small-scale communities. If such a system emerges, it could lead to a similar degree of centralization to today’s third-party escrow operators. It’s important that the market is able to interpret all of these considerations (and hopefully more that I haven’t yet understood).

eCash is more private and unrestricted than Bitcoin and LN (Lightning Network). In addition, eCash also provides stronger collateral protection than third-party escrow providers.

Free Bank vs 100% Reserve System

A systemic consideration worth exploring is whether eCash is likely to exist in a fully or partially covered system, and what does the two look like? Consider the following table, which represents each type of credit and its associated risks:

An illustrative classification of the type of credit, the major issuers, and the associated risks

The vertical column shows the three main categories of credit issuers: peer-to-peer (P2P), intermediaries, and intermediaries who also issue a form of private medium. These three types of issuers can also issue various types of credit, which also maintain a variety of risks given the type of credit they are promoting. We can see that the issuer type limits the ability to issue certain types of credit, and thus the level of risk associated with the issuer:

**1. P2P (peer-to-peer) :**Credit issued in the P2P economy is subject to maximum restrictions. Individuals can provide credit in kind and do not need to make a formal loan – providing a service and deferring payment until a future date. This can be receiving a beer from your local pub and paying for it the following week, or extending the payment period from 30 days to 60 days from the accounts receivable contract. Peer-to-peer loans can also be provided with or without guarantees. While private credit and loan issuance in the P2P economy will certainly exist on a large scale, lending also requires the professionalization and economicalization of intermediaries. As a result, some form of intermediary will exist to provide loans. In all of these forms of credit, the issuer is exposed to the risk of default.

**2. Intermediary: A credit issued by accepting a deposit and granting a loan. The key difference in this column is that these intermediaries provide loans directly in Bitcoin (or via the Lightning Network) rather than issuing their own media or payment methods (e.g., eCash). These intermediaries accept deposits and are associated with the conditions of their contracts. If these are fixed deposits, then there is no risk of a bank run, as the depositor cannot withdraw until the contract term is at least met. However, if they are demand deposits, depositors can withdraw them at any time, and there is a risk that the term of the deposit does not match the term of the loan. As long as the deposit tenors do not match, there is a risk that the intermediary may run on the risk. Even full-fledged institutions that do not have a mismatched maturity of their deposits can go bankrupt due to a situation where the borrower defaults and the non-performing interest rate exceeds the total interest. In addition, intermediary systems are more susceptible to political control because they are institutions that are subject to the laws of various jurisdictions.

**3. Private Medium Issuers: If an intermediary issues their own private medium (e.g. eCash), then they will be providing loans in their own specific form of medium, which is backed by Bitcoin. Intermediaries that issue private media are at risk of managing part of their reserves. They can also be a full-fledged institution that backs their private medium 1:1 in Bitcoin. The risk of a run is similar to that of an intermediary that does not issue a medium if fully reserved, but the risk of a run is much greater if partially reserved. In addition, as history has shown us, some reserve agencies are more prone to failure, creating a favorable environment for regulatory encroachment. With the increase in encroachment by regulators, there is a greater risk that the entire system will eventually become a fiat monetary system.

All of these systems are likely to emerge in the Bitcoin ecosystem. If we apply this framework directly to the system of joint eCash issuers, we will find that if the scale is expanded, the risk of some backup institutions is possible. But this is an even more dangerous situation. The efficiency that comes with the digital and cryptographic nature of the system will make partial provision a dangerous and unsustainable business model. In addition, Bitcoin’s base supply is not affected by a central authority, so credit issuance cannot be systematically manipulated. Considering these two characteristics of Bitcoin’s local financial system, the issuance of partial reserve credit will be limited by local practices and can only be sustainable in the short term. The partial provision system is by no means the only way to achieve credit. As discussed earlier, the technical capabilities provided by Bitcoin, the Lightning Network, eCash, and the consortium form a powerful toolkit for building systems toward a full reserve standard with a strong enabler towards peer-to-peer credit.

However, the emergence of a full reserve standard (100% reserve) is not a certainty, and specific incentives may give rise to a partial reserve provider: the right to tax. Defined as the difference between the cost of issuing money and the market value, the taxing right creates an incentive for intermediaries to issue more private media on more lenient terms in order to increase their economic profits. While many aspects of the free banking system limit the extent to which taxing rights can be reasonably drawn, it does not eliminate the incentive to at least try to tax.

However, the credit system can be implemented without a partial provision system. The ability to exit the system and operate peer-to-peer on the Bitcoin and Lightning networks will be a major deterrent to an unsustainable partial reserve system. As peer-to-peer self-sustaining economies emerge to compete with the custodial financial system, it will become more challenging to operate fractional reserve institutions in highly competitive conditions. Competition with peer-to-peer systems is only one of the hindrances, and in addition to the other factors described earlier, it remains to be seen which technologies will ultimately best incentivize peer-to-peer or full readiness regimes to become the standard.

Topically, the world has witnessed in 2023 how the risk of a well-coordinated run in the online economy is happening. Information travels at the speed of light, and consensus can quickly form information about the financial status of an institution. Mobile banking makes withdrawals easier and significantly faster. Bitcoin is a permissionless asset that can be teleported through the Lightning Network. The transparency of information achieved through the internet, mobile technology, unilateral exit from the protocol, and Bitcoin could dramatically increase the risk of partial reserve system going bankrupt for such a short period of time that it becomes impossible in practice to operate such an institution.

Returning to the concept of community trust, the advent of the Internet has redefined communities to exist not only at a geographical or genetic level, but also at a global level defined by common interests. Bitcoin also enables online communities. A community is a group of individuals organized around a common interest, and for people to be organized, they must have the ability to make transactions. Bitcoin has enabled online communities to organize, transact and transact without permission, thus forming communities. We do not yet fully understand the full scope of this organization and its potential.

Set aside the Fedimint protocol and consider the technology of just a co-custody model in some form. This model requires trust, and the ease of application at the local level increases the potential for the system to remain decentralized. However, it can also create security in a distributed online format. Various communities across the globe can use this technology to bypass geographical barriers and form communities in a safer, less trust-based way.

The incentives are targeted at the emergence of Bitcoin’s native free banking system, and technological advancements are expected to prevent partial reserve banking from becoming a sustainable business practice.

Innovative Technology

Discuss how to further develop the technology to make this theoretical system possible. So far, we’ve discussed technologies such as the Lightning Network (LN), federations, and eCash. The combination of these technologies has enough characteristics to enable the incubation of a digitally native financial system, but the system is not perfect enough to benefit from further development of technology.

One of the technologies that is currently in the theoretical stage can solve some of the problems proposed in the federations, lightning network (LN) and eCash systems:

1. Fedimints do not offer a unilateral exit option (but the Lightning Channel does).

2.** The Lightning Network is structurally conducive to centralization.

3.** When it comes to attracting users, both the co-mint and the Lightning Network are limited by block space and transaction fees.

ARK Protocol

ARK is an innovative protocol that aims to solve a number of problems. The technical mechanics will not be explained in detail here, but will focus on the goals of the project, as the protocol is currently still in the conceptual stage. ARK is a unique protocol that brings together a variety of other technologies. Similar to CoinJoin, Ark is a coin mixing service. Similar to channel factories, ARK is a network access mechanism that reduces on-chain footprint. In the same way that LN has a Local Service Provider (LSP), Ark will have an Ark Service Provider (ASP).

Roughly speaking, individuals can access the network to ASP, allowing users to enter the system in bulk, thereby reducing their on-chain footprint. This is done by locking the bitcoins to a 2-2 multisig address along with the ASP, and then receiving a pre-signed transaction from the ASP, providing one of the two signatures needed to send the bitcoins back to the user himself. With pre-signed transactions called VTXOs (Virtual Unspent Transaction Outputs), users of ASPs can exchange these transactions with each other for payment. With this onboarding, users can hold their bitcoins within the ASP and remain unilateral in the event of negligent or malicious acts. It’s a solution to the onboarding problem and also provides a trustless hosting solution. These features make Ark a potential protocol that can further complement the consortium, the Lightning Network, and the eCash system.

As a practical example, ASP may be an ideal service provider for buying Bitcoin through trustless cost sharing. Imagine thousands of individuals buying Bitcoin at the same time across the globe, all on the same schedule, all together in the same multisig transaction.

How ASPs will be used for payments is uncertain, as they require significant capital reserves to support payments. The maximum amount of potential payouts cannot exceed 10.5 million BTC, as all payout volumes made via ASP need to have an equivalent amount of reserves within 4 weeks. Since the total amount of bitcoin is only 21 million, at most only half of it can be used for payments, as the other half must be reserved as a reserve to make these payments. Ultimately, it will depend on the amount of value represented by 10.5 million bitcoins to determine the total transaction capacity of the network. The following table represents the simplified theoretical transaction throughput of the network and various scenarios that depend on the average size of transactions:

An exemplary Ark trading (VTXO) economic model that simplifies the system without taking into account the total capital reserves within the system and the costs associated with the trading mechanism.

It is theoretically possible to achieve a transaction-per-second (TPS) comparable to that of the Visa network (about 60,000 transactions per second), provided that the average transaction size is 100 bits. However, this may be a less appropriate comparison. If ASPs are primarily used for deposits and custody, similar to banks, then the appropriate payment network comparison should be compared to bank settlement networks. From this perspective, ASP’s ability to facilitate payments may be far superior to existing banking infrastructure.

Comparisons aside, the most interesting thing about VTXOs as a means of payment is that as the value of Bitcoin continues to increase, they become more capital-efficient. There are some global average payout sizes, which are fixed, and the value of Bitcoin is expected to increase significantly (and probably continue to increase). As Bitcoin represents more value in the world, so does the potential of VTXO as a global payment layer. In other words, as the Bitcoin network represents more value globally, the cap on the required capital reserves (10.5 million bitcoins) represents more value, and the average transaction size becomes a smaller part of it.

Fundamentally, a key point here is that tomorrow’s payment network may not be the day after tomorrow’s payment network. The most meaningful payment protocols today may not make as much sense as the decline in payment costs proportional to the capital constraints of the system.

Still, the reality of this system will be much more complex than this theoretical discussion, with existing protocols offering different and potentially better payment capabilities. The Lightning Network can provide transaction throughput with a lower cost of capital. eCash is an ideal medium for low-value high-frequency transactions but requires trust, while the Lightning Network is equally valuable but less private and subject to liquidity constraints. All of these protocols have valuable features that are reflected in potentially optimized federal service providers that use eCash, LN, and Ark.

As far as the point of view currently discussed, Ark cannot be implemented without CTV, TXHASH, or element opcode soft forks, and the risks of the protocol need to be considered. As previously discussed, the capital efficiency of payments (and therefore the cost of capital) is an important consideration and may be a major driver of the protocol’s adoption. There are other attack vectors to consider, such as denial-of-service (DOS) attacks:

Attacks against users: Exiting an ASP is voluntary, but entering an ASP is not. While ASPs provide users with a unilateral right to opt-out, they also have the right to deny users access or ongoing participation because they do not have to provide users with access or exchange payments on their behalf. Similar to banks, users must trust that they will have access. If such a system achieves critical quality, there may be a blacklist for participation. It is worth noting that this risk is common to all service providers, and the development of P2P systems is the solution. Federated infrastructure could be a potential solution to DOS attacks on users, which is another argument for multi-protocol service provider optimization.

Attacks against ASPs: DOS attacks are possible against ASPs and arbitrary transactions can be made to force the ASP to maintain an impossibly high or very expensive reserve balance. However, the capital cost of such an attack can be so high that only those attackers with a significant interest in ASP’s competing systems will be economically viable.

Forced expiration spam: As described in the original LN whitepaper, it’s like in the Lightning Network or any multi-party contract setup, if a large-scale, intentional or unintentional user failure requires many other users to put a lot of time-related transactions on the blockchain at once, i.e., in LN or any multi-party contract setup, such as Ark, there is a massive, intentional or unintentional user failure, which requires many other users to put many time-related transactions on-chain at the same time. In the case of Ark, if the ASP is permanently offline, then everyone needs to withdraw before their funds are confiscated to the ASP. This issue can cause serious user and network problems when it is least desirable.

For now, though, Ark seems like a unique and viable solution. Most interestingly, Ark may be necessary to implement a protocol for trustless banking. The Lightning Network can be used without a service provider, but Ark cannot, just like a bank. VTXO (Ark Pre-Signed Transaction) is another payment method, but cryptographically guaranteed to be fully reserved. Similar to trustless bank checks, VTXOs aren’t just as reliable as gold, they’re as reliable as Bitcoin. Taken together, the ARK protocol can provide the necessary infrastructure for a trustless service provider’s free banking system, removing agents from essential economic functions. From there, a functional lineage of various financial functions emerged, from fully centralized custody operations to managed LSPs, to federated custody, trustless ASPs, and pure P2P systems.

By applying cryptography solutions to basic financial functions, agents can be reduced throughout the financial system. Emerging technologies in the homegrown Bitcoin ecosystem continue to showcase novel cryptographic innovations.

Final thoughts

Many of the concepts discussed in this article are theoretical in nature, while some are real techniques for solving today’s practical problems. A protocol stack is becoming the foundation for Bitcoin-based banking and financial services in general. One part of the stack is a layered protocol that can keep a one-way exit, while the other part is a trusted design.

Imagine a system where users invest in Bitcoin through Ark, use federated technology for escrow, use eCash as their private cash balance for daily transactions, and in the background, all service providers settle balances between each other via LN. Federal mints and ASPs can act as banking infrastructure, while LN can act as a clearing center between them, with a hub and spoke model. In addition, technologies like the Web-of-Stakes reputation management system and the limited-time eCash Proof of Reserves system can promote competition and information transparency.

The P2P autonomous financial system is irreducibly complex. Centralized systems are needed to support the transition to decentralized systems. However, once the necessary infrastructure is in place, autonomous systems can incubate digital-native capital markets at scale and help cement Bitcoin as the standard unit of account. The larger the settlement volume of Bitcoin, or in some way related to Bitcoin, the greater its chances as a unit of account.

The system described bears a striking resemblance to historical banking systems, but it harnesses the power of cryptography to remove agents from various financial functions and optimize where it is still necessary. The complexity of incentives is a major risk to this vision, but if information transparency is high and competition is fierce, the free market will solve the problem in a way that no individual can imagine.

At the end of the day, what matters is that decentralized custody and the choice of features around P2P finance can pre-empt the inevitable centralization in the banking industry, and that technology makes censorship and inflation obsolete.