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In both the crypto markets and the traditional financial markets, there has long been the view that the custody of these assets must be passed on to a third party in order to earn interest on one’s own assets. But with the Lightning Network (LN) from Bitcoin (BTC), a new model for achieving a non-custody “Lightning Network Reference Rate” (LNRR) has emerged, argues one author.
According to Nik Bhatia, associate professor of finance at the University of Southern California and author of the book Layered Money, the market for so-called routing fees in the Bitcoin Lightning Network could serve as the first form of “counterparty-free income” for capital owners in the future.
“The smart contracts within LN allow its participants to establish a market for routing charges, and routers can generate a return on bitcoins without ever relinquishing full control of the underlying capital,” Bhatia wrote on a recent blog -Article on Bitcoin Interest Rates.
He added that in traditional financial markets, returns cannot be achieved without entrusting capital to a counterparty.
“How can a corporation, for example, return income to investors without first having to hold debt capital themselves? Impossible, ”wrote the popular author.
Although the Lightning Network routing fees can be earned without giving up the custody of the bitcoins used, they are still not a completely risk-free interest rate as typically seen on government bonds in the traditional financial system. The network is young and there may be unknown risks or security vulnerabilities.
Additionally, routing fees aren’t the only interest rate that can be derived from a future Bitcoin economy, argued the author.
Other potential sources of income in a future Bitcoin economy could also include fees for mixing coins, funding rates for Bitcoin futures or bills of exchange, and lending. The notable difference, however, is that all of these activities involve counterparty risk in some form.
Taken together, all of these rates can create a “robust yield curve” in the Bitcoin market that will evolve into investment strategies based entirely on “the Bitcoin diversified complex,” Bhatia concluded.
In the past, other attempts to establish a risk-free interest rate for bitcoin similar to the yield curve for US and European government bonds, mainly focused on the regulated futures market for bitcoin.
Including a research article by Quantpedia.com considered the rate that could be earned by long position on the front month Bitcoin futures contract in the regulated market Chicago Mercantile Exchange (CME), while at the same time the longest running (back month) contract is being sold short.
This would create a position that would not be exposed to the price fluctuations in Bitcoin, but instead exploited the price difference between futures contracts of different maturities.
And although the counterparty risk in this case may be low, since the CME is a regulated futures exchange, the risk is still there and no returns can be achieved without giving up the custody of the bitcoins.
Others, meanwhile, agree with Bhatia’s view that the only counterparty-free rate on Bitcoin is the one that can be derived from the Lightning Network’s routing fees.
According to Patrick Heusser, Head of Trading at Digital Asset Brokerage Crypto finance, a “Lightning Network Reference Rate” could even have an impact on the pricing of Bitcoin derivatives. This is because the price means that the “opportunity cost of Bitcoin becomes measurable”
And, judging by Heusser’s research, a Lightning Network Reference Rate might actually be even less risky than assets that are normally considered risk-free in traditional finance.
“The Lightning Network, controversial, and the resulting LNRR is associated with fewer risks if the necessary knowledge to deal with the operational risks is available,” argued Heusser and finally added:
“However, it is certainly not wrong to regard the LNRR as risk-free if your unit of account is Bitcoin.”
In other words, it seems that fees from Bitcoin’s Lightning Network could have a real chance of becoming the first benchmark rate that is risk-free and counterparty-free at the same time.
The old wisdom that Bhatia summed up by saying that “returns are never achieved without sending capital to a counterparty” could be turned on its head.
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