Lightning and Legislation – the regulatory considerations of moving to layer 2

Lightning and Legislation – the regulatory considerations of moving to layer 2

While the mainstream is finally waking up to the fact that Bitcoin’s applications extend beyond the criminal domain, it’s taking the US government a while to warm to the idea. Where many see ‘freedom from the legacy financial system’, the regulators see ‘attack on fiat institutions’. When the incumbents aren’t hailing Ripple as the new Bitcoin, shouting ‘bubble’, or (my personal favourite) comparing a digital currency to tulip bulbs, they’re busy trying to crack down on cryptocurrency use.

So far, I think we can all agree that that’s not gone too well in terms of regulating the currency itself – instead, regulation has mostly targeted methods of converting fiat-to-cryptocurrency and vice versa, as well as businesses dealing with virtual currency (the draconian Bitlicense is a prime example). From a tax standpoint, the IRS view Bitcoin as property, and expect gains and losses to be reported (and even subpoenaed Coinbase for information on users).

Scaling the blockchain is arguably the greatest challenge posed to the long-term prospects of Bitcoin. Many are awaiting the deployment of the Lightning Network as a second-layer solution. The LN allows scaling by facilitating off-chain transactions. I like to recommend Aaron Van Wirdum’s three-part explanation.

The structure of the Lightning Network has spawned a lot of questions, particularly with respect to the legislation under which it may find itself regulated. There appears to be a great deal of uncertainty over whether a node in the network, given its role in moving funds, amounts to an MSB (money service business) under US law.

If found to be acting as a money transmitter, a node will need to register with FinCEN, and adhere to the Bank Secrecy Act requirements that apply. I’ll save you the trouble of clicking on the link: it’s a lengthy list of measures to be taken that would heavily monitor transactions and impose sanctions on anyone failing to comply. For those accustomed to running a regular Bitcoin node, setting up a compliant Lightning hub could entail a lot more effort than powering on a Raspberry Pi and running a few lines of code.

Some have suggested that the closest parallel that can be drawn today is that of Automated Clearing Houses (most of the similarities seem to rely on the fact that the two entities act as electronic intermediaries). ACHs are exempt from the IRS rules qualifying them as third party settlement organisations.

However, even the ACH comparison falls short in certain regards. Pseudonymity is all-too-easy to maintain on the Bitcoin network, so that a node operator would be clueless as to the nature of the transactions their node facilitates. Conforming to KYC/AML procedures would not only be a headache, but impossible.

The truth is, there’s really no way of knowing how things are going to go. Even FinCEN’s guidance on virtual currencies remains incredibly ambiguous. If the LN amounts to what legislators deem to be a threat, we’ll undoubtedly see new regulations spring up. How they might go about this is beyond me – the use of onion routing would surely make such measures impossible to enforce. The distributed and global nature of the Bitcoin network is another consideration. Jurisdiction exists within borders, but cryptocurrency does not.

The biggest threat to the Lightning Network, in my opinion, is how we see it distributed. If a hub-and-spoke model arises (transactions from many small nodes all being routed through several large ones), the hub becomes a point of failure, and an attractive target for those wishing to regulate layer 2.

Featured image from Pexels

About The Author

Matt B

Law graduate and crypto journalist


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