FED Branch: Lightning Turns Bitcoin Into Money

For The Federal Reserve Bank of Cleveland, the Lightning network favors the use of bitcoin as a means of payment.

Door to the walk-in vault in the Winona Savings Bank in Winona, Minnesota, United States
FED Branch: Lightning Turns Bitcoin Into Money (Source: Wikimedia Commons)

In Short

  • Research shows that the Lightning network decongests bitcoin.

  • This micropayment network would make greater acceptance of bitcoin possible, the Bank says.

  • CBDCs could promote financial system stability.


According to the Federal Reserve Bank of Cleveland, the Lightning network turns bitcoin (BTC) into money by facilitating its use for micropayments in the United States. The FRBC puts it in its recent report "Lightning Network: turning bitcoin into money [PDF]," written by researchers Anantha Divakaruni and Peter Zimmerman.


After an overview of how the Lightning network works, the authors conclude that developing this second-layer scalability solution "may have consequences that improve the user experience." That could "make it possible for a currency based on a non-permissioned blockchain to gain widespread acceptance."


For their research, Divakaruni and Zimmerman did not simply reproduce existing literature but conducted tests themselves. They report that to prove that the adoption of the Lightning network is associated with a reduction of congestion in the Bitcoin network, they constructed congestion measures using mempool data.


The results lead them to state that "the higher usage of the Lightning network is associated with a significant reduction in mempool congestion." Furthermore, "given that there is no theoretical upper limit to the growth of the Lightning network, there is the possibility of further reductions in congestion in the future."


The Cleveland Fed paper states:

"Our findings suggest that (...) the Lightning network can help Bitcoin scale and function better as a means of payment. Marakov and Schoar study blockchain data and suggest that most of Bitcoin's use is for trading and speculation. Still, their analysis does not extend to Lightning network transactions." Divakaruni, Zimmerman from the Federal Reserve Bank of Cleveland.

The Cleveland Fed has organized conferences on financial stability, in which bitcoin and cryptocurrencies were part of the topics addressed.

CBDCs and the financial system stability

A few months back, the White House authorized an investigation into whether there is the potential for Central Bank Digital Currencies (CBDC) to be helpful to the financial system or destabilize it in various ways. As a result, the U.S. Treasury's Office of Financial Research (OFR) decided to undertake an exhaustive study, and now we have a rather exciting conclusion that we will explain below.

The cost of a liquidity shock

Now, according to the document shared by the U.S. Treasury's Office of Financial Research, there's a probability that a CBDC will not generate instability [PDF] in the country's banks. Likely, it will not affect the smaller ones either.


Their arguments explain that people withdraw much money from banks in times of financial stress, and a CBDC could aggravate these runs. However, they argue that there may be a way that a CBDC could mitigate these risks and provide financial stability.


Going into more detail, the paper's authors explain that


"you can create a mathematical model in which banks borrow money at shorter maturities than at present. In such a way, lower liquidity risk leads to financial fragility in an adverse event, which could eventually lead to a run".

As a result, they add: "access to a CBDC intuitively makes experiencing a liquidity shock less costly. Therefore, banks can provide less insurance against this type of risk. And basically, CBDC would bring stability to the financial system".

Quickly Identify risk situations

Regarding other details, the Treasury studies indicate that a CBDC may allow governments to identify risk situations more quickly. Decision-makers will be able to study conditions before the problem becomes too big. As a result, they can achieve faster solutions to problems already identified.


"By allowing a faster policy reaction to a crisis, this information effect is another channel through which a CBDC may tend to improve rather than worsen financial stability."

Finally, they urged governments to restrict the use of CBDCs during economic downturns, in addition, to imposing caps, and fees, among others. However, this would limit the attractiveness of a CBDC so that many of its potential benefits would get lost.

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