The Time Value of Bitcoin and LNRR

Nik Bhatia
22 min readApr 18, 2019


1. The Bitcoin Second Layer

Bitcoin’s antifragile protocol and its exponentially increasing network effects make it a behemoth, gradually swallowing up global economic activity. The latest of these network effects is a second layer protocol called Lightning Network, which uses bitcoin’s base layer protocol as its security. The concept of layered money is not new in monetary history. In this writing, I’ll be using gold as an analogy to describe why bitcoin will evolve in layers on its way to world reserve currency status.

Layered Money

Gold has served as money for millennia due to its unique chemical properties and its global network effects. But gold has not acted as money only in its raw physical form, or on its first layer. Gold is a perfect example of how a layered money system evolves. Let’s take a look at gold as money in a four layered example. I’ll describe the rule set, or protocol, of each gold layer so the reader can imagine similarities to bitcoin’s layered protocol approach.

The first layer of gold is the physical gold in its raw form after it is mined: gold nuggets. The protocol of gold’s base layer has only one rule. The element must adhere to the properties of the periodic table’s 79th element. If it does, it is gold; if it does not, it is not gold. Consensus around this “79th element” protocol is millennia old.

The second layer of gold is raw gold that has been melted and shaped into bars and coins following a standardized protocol of purity, weights, and measures. Mints can be controlled by governments or by private enterprise, but the coinage will only be considered money by users if the “79th element” first layer protocol is followed.

The third layer of gold is gold certificates. These are claims issued by banks that have taken gold on deposit. Third layer banks will only use gold coins and bars that follow the consensus second layer protocol of purity, weights, and measures and only from mints that are properly following the “79th element” protocol. These certificates can act as money but carry counterparty risk of the issuer.

The fourth layer of gold is certificates backed by bank-issued gold certificates. A liquidity provider can issue these certificates, which would require several layers of trust by the user. Somebody accepting fourth layer gold as money has to trust that the liquidity provider has real gold certificates, which are backed by physical gold at a bank that follows a standardized purity for gold deposits.

Each layer uses the layer beneath it for consensus and security. Money will always see a multiple layered expansion as it evolves, and each layer has costs and benefits. You can mine your own gold, but this process is very expensive with a high barrier to entry. You can buy gold coins and bars easily in most parts of the world, but using them for day to day commerce is unfeasible. As a merchant, you can accept gold coins but either have to trust the purity or assay the gold yourself. Once you’re using the paper certificate layers, you now are engaged in counterparty risk, but have easier capacity for transactions. Each layer serves a different function. Base layers are for final settlement, while higher layers are for facilitation of economic activity.

Bitcoin’s First Layer

Bitcoin’s first layer, or base layer, is a protocol proposed in 2008 that has reached a global state of consensus. Bitcoin’s unit of account, also called bitcoin, has exchange rates with currencies around the world in markets that are growing in depth and liquidity. The protocol itself has added vital updates in its young life that have strengthened both security and usability. The network’s uptime and its ability to prevent double spends are relentless.

Critics of bitcoin often incorrectly identify a feature of bitcoin, its slow speed, as a flaw. Bitcoin’s confirmation process is meant to be slow because of security reasons. The intent of bitcoin is censorship-resistant, scarce digital cash, not a speedy payments solution. The best way to think about bitcoin’s base layer protocol is as a final settlements layer. The final settlement of physical gold is also a slow, clunky, and expensive process. Imagine, for example, companies in different parts of the world settling large balances of gold by loading ships with physical gold bars and sailing fortunes hundreds of miles across seas. Not only is the delivery an arduous process, but the verification process is also quite a task. In theory, every single piece of metal would have to be tested for purity. This process should be considered as historical context for what is required to have true final settlement of scarce money. The energy consumption required to find valid blocks has dramatically increased over time which increases security, but difficulty adjustments ensure bitcoin still averages six blocks per hour.

Centralization and attack vulnerability, while both permanent concerns to owners of bitcoin, have not prevented huge sums of capital to be stored in bitcoin’s denomination. The denomination, commonly known as BTC, despite its commonly quoted exchange rates with fiat currencies, stands alone as a final settlement asset. With a secure and reliable final settlement layer firmly in place, development of higher layers can ensue: enter the Lightning Network.

Bitcoin’s Second Layer

Lightning Network is a second layer protocol on top of bitcoin. The protocol uses bitcoin as its native denomination, meaning that Lightning can only be used by those with real bitcoin. Under the hood, Lightning Network is a web of bidirectional payment channels, but the protocol’s functionality is beyond the scope of this writing. The important takeaway is that Lightning allows for the instantaneous transfer of bitcoin from peer to peer with one considerable difference from the first layer: channel balances can adjust but do not require immediate settlement on the base layer. Simply stated, Lightning transactions are unsettled bitcoin transactions.

Having unsettled bitcoin comes with risk, however. Bitcoin held in Lightning Network payment channels can be stolen by malicious actors if node operators are not properly monitoring the channels and the base layer. Malicious actors have a strong disincentive to steal, however, as fraudulent activity gives the victim ability to sweep all funds from the channel. Now that we have covered some of Lightning Network’s basics, let’s take a look at the importance and the significance of this new layer on top of bitcoin.

The Importance of Lightning

Firstly, the Lightning Network is a zero sum, fully reserved routing network.You may only use Lightning if you bring in real bitcoin, and all routing fees earned by liquidity providers are paid for by liquidity consumers. This allows Lightning Network to operate with one of the primary features of bitcoin, its limited supply.

Secondly, Lightning does not carry the burden of base layer confirmation. This allows for bitcoin to be exchanged ad infinitum without consuming precious block space. Lightning nodes can decide to take final settlement of their bitcoin by broadcasting the correct state of a payment channel to the base layer at any time, but they don’t have to.

Lastly, Lightning transactions can be interpreted as financial agreements, making Lightning Network a capital market layer. The network’s structure is built as a market for capital and liquidity. Bitcoin can now instantaneously fly around the world without having to wait an hour for final settlement. The two core components to any financial transaction, time value and risk premium, can be derived from Lightning transactions. Opportunity cost tradeoffs can be calculated, and bitcoin can be leased on a short term basis to the network without surrendering one’s private keys. With gold, there is no way to accrue positive interest on capital without surrendering the physical metal. This makes Lightning Network an absolute game changer for the entire concept of capital markets: income without explicit counterparty default risk.

Digital Gold

Bitcoin is often referred to as digital gold, but I’ll propose a more specific analogy. Bitcoin’s base layer is like digital physical gold, while Lightning Network is like digital paper gold but without the counterparty risk. The second layer is unsettled and less secure, but infinitely more usable. Bitcoin is incredible at censorship resistance and decentralization, but frankly terrible at speed and efficiency. Critics of bitcoin completely miss the fact that speed and efficiency should take place on higher layers, NOT on the base layer. Lightning’s arrival will show the world bitcoin’s true capabilities. If gold could only be used as a physical metal, global economic activity would have been prohibitive on a gold standard. Thankfully, paper gold satisfied the liquidity and capital market layer. Lightning Network ensures bitcoin’s path to global reserve currency because it makes bitcoin come alive. Once bitcoin can be transacted around the world without the constraint of a slow confirmation process, it can graduate from reserve asset to reserve currency. Lightning Network finally frees bitcoin from its base layer shackles.

2. The Time Value of Bitcoin

The HTLCs in Lightning Network give bitcoin a path to become a global reserve currency. Lightning Network provides a framework to measure the time-value of bitcoin, a precursor for a capital market and reserve currency status. Observable variables in Hashed Time Locked Contracts can be used to calculate the interest rate received on bitcoin held in payment channels, allowing investors to measure their opportunity cost of capital. Lightning Network wallet software should include ways to calculate interest and prove the rate received in a trust-minimized way. A reference rate should be developed, using consensus to dictate how the rate is calculated. This reference rate can anchor off-chain bitcoin lending into the global economy, leading to bitcoin-denominated banks, credit ratings, debt capital markets, and eventually an entire financial system: a path toward status as a global reserve currency.

Calculation Method

Three observable variables are needed to calculate an interest rate: principal, cash flows, and time. In Lightning Network, the principal is the amount of bitcoin in a payment channel; cash flows are routing fees; time is the block-time in which the fee collection is measured. Wallet implementations should experiment with different interest rate calculation methods with the eventual goal of a consensus method. The US Dollar has Treasuries, Fed Funds, LIBOR, OIS, and SOFR all acting as reference rates within the capital market for lending, borrowing, and swapping cash flows. Bitcoin needs to establish a reference rate of its own, referred to in this writing as LNRR (Lightning Network Reference Rate).

There are many possible ways to calculate LNRR. Principal may be measured once per block or using an average over time. Fees may be measured for individual HTLCs, individual payment channels, or Lightning Network nodes with multiple channels. Block-time may be measured by the locktime of HLTCs or measured one block at a time. Compounding conventions may be discrete or continuous. On-chain fees paid to open and close channels may be included or excluded in the calculation. We need to experiment with calculation methods because bitcoin is an entirely new asset class and shouldn’t adhere to financial conventions of the past, even though traditional fixed income markets set the bar extremely high for financial sophistication.

Time-value of bitcoin

Fees, time-value, and security risk premiums are discussed in the The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments by Joseph Poon and Thaddeus Dryja:

The time-value of fees pays for consuming time (e.g. 3 days) and is conceptually equivalent to a gold lease rate without custodial risk; it is the time-value for using up the access to money for a very short duration.

Historically, one of the largest component of fees and interest in the financial system are from various forms of counterparty risk — in Bitcoin it is possible that the largest component in fees will be derived from security risk premiums.

Fees in Lightning Network can be attributed to two components, time-value and security risk premium. Fees compensate the leasing of bitcoin which translates into time-value. Positive interest rates should attract capital and competition. But Lightning Network node operators investing capital are not doing so purely risk-free. They are taking on a variety of risks, most notably the risk of using hot wallets to stake liquidity to the network. Therefore, interest rates will vary between nodes due to different security practices, captured here by the catch-all variable security risk premium.

r = time-value + security risk premium

Lightning Banks

Lightning Network will birth Lightning banks. Their first function will be to provide liquidity to Lightning Network by funding payment channels. They will try to position themselves as central routing hubs, capturing as many fees as possible. Competition will be open and fierce. Those with the greatest ability to efficiently manage payment channels and actively optimize routing positioning will profit.

Reference Rate

LIBOR was originally intended as an inter-dealer interest rate, however market conditions and manipulation scandals have significantly changed its role. Despite its evolution, LIBOR’s model could serve as an example for LNRR to follow. The calculation method for LIBOR is essentially a panel: banks are asked to submit rates and these rates are aggregated to form a reference rate published once a day. Lightning banks can publish their interest rates to each other in order to foster a dealer community similar to the LIBOR panel banks. Any node that can publish an interest rate can potentially contribute to LNRR.

Once Lightning banks establish LNRR, they can reference this rate and charge a spread for loans that are not secured by the Bitcoin blockchain. They can use the reference rate to attract deposits which would also not be secured by the blockchain. While off-chain, trusted, bitcoin denominated capital market activity does not benefit from Bitcoin’s immutability, it is essential for the establishment of bitcoin as a currency capable of global economic activity. Economic activity requires a tradeoff between time preferences which can only be achieved when savers are allowed to lend capital.

Reserve Asset to Reserve Currency

LNRR is not some magic solution. This paper is a suggestion to the Lightning developer community to start experimenting with the translation of HTLCs to a financial framework. We cannot go from Trace Mayer’s sixth network effect of financialization to the seventh network effect of reserve currency status without the correct financial tools. Bitcoin has already emerged as a new asset class and is now acting as a reserve asset for millions around the world. Transitioning from reserve asset to reserve currency will present a challenging path. Ideas like LNRR should be discussed and explored so that we can continue to push bitcoin forward as the world’s best abstraction of money.

3. The Bitcoin Risk Spectrum

Bitcoin is already a reserve asset. It is the world’s first true example of decentralized digital scarcity, and its elegant, predetermined supply schedule reinvents monetary policy. Its value is recognized by millions of people who own bitcoin as a savings vehicle, speculative investment, or currency hedge. Bitcoin is a reserve asset because millions of people own it as one. Its next step is to transition from a reserve asset to a functioning reserve currency by unlocking the bitcoin capital market. Lightning Network’s arrival finally allows us to assign time value to bitcoin, and we can begin building bitcoin’s capital market from first principles.

Lightning Network’s HTLCs

HTLCs are financial agreements with two important properties that eliminate reliance on trusted third parties. Firstly, the contracts have an embedded call option on the counterparty’s bitcoin which dissuades theft. Secondly, the contracts have an expiration, which prevents balances to be held in limbo to perpetuity. These two properties remove counterparty risk but instead introduce payment channel management risk. Routing Lightning payments is the equivalent of a short-term bitcoin lease and allows the router to earn fees; these fees can be used to calculate interest earned on bitcoin staked to Lightning payment channels.

Traditional Capital Markets

Traditional capital markets have a risk spectrum: generally speaking, higher variance of returns is positively correlated with a higher expected return. More risk, more reward. It is important to note that risk-free rates are entirely conceptual and theoretical. They are simply a matter of convention to facilitate financial theoretical research and improve communication. Therefore, this article is an attempt to discuss and derive bitcoin-native financial theory, including how bitcoin can be reconciled against other assets. Bitcoin is still trillions of dollars of market capitalization away from becoming a legitimate alternative to other deep capital markets like the ones denominated in US Dollars, Euros, Yen, Pounds, and Yuan. Before we dissect bitcoin’s risk spectrum, let’s take a look at that of the US Dollar to get a sense of which aspects bitcoin should copy and which it should reinvent.

US Dollar Risk Spectrum

Why is the US Dollar the world’s reserve currency? There are many reasons including geopolitical and economic prowess, but one of the reasons is the depth of its capital market. There are over $100 trillion in bond and equity securities, allowing owners of US Dollars to easily find a home for them. Its capital market can be viewed as a risk spectrum, with risk on the x-axis and expected return on the y-axis.

US Dollar Risk Spectrum

The first point (illustrated) on the risk spectrum is US Treasury debt. Financial theory requires a risk-free asset to establish baseline interest rates, and currently that asset is US Treasuries. The obvious flaw of this financial theory is that US Treasuries are not truly risk-free. They have default risk, albeit appropriately characterized by market as the lowest possible default risk that an investor can attain. (Many sovereign bonds now have yields lower than yields in the United States, but those bonds are not denominated in US Dollars. This article is written only comparing bitcoin to the US Dollar).

The second point is corporate bonds. Companies issue fixed obligations at a spread to US Treasuries; for example, this year Walmart issued a 5yr bond at 5yr Treasuries plus 0.60% and General Motors issued a 5yr bond at 5yr Treasuries plus 1.37%. Each of these companies used the 5yr US Treasury as a reference rate. Investors consider the risk premium, or creditworthiness, of each company relative to Treasuries. We can see from this example that bond investors view Walmart as more creditworthy than General Motors because Walmart borrows at a lower spread to Treasuries. This is why reference rates are considered an anchor for debt capital markets, because they more easily allow for relative value comparisons.

Further along the risk spectrum are investments with higher risk profiles, such as publicly traded equities and venture capital funds. Theoretical formulas for the expected return on equities usually include a combination of the risk-free rate and the company’s risk premium. Venture capital investors will seek an even higher return because the probability of principal loss is perceived to be higher than that of public equities. Theoretical risk premiums are added to each subsequent point of the risk spectrum, all anchored from the risk-free rate.

Bitcoin Risk Spectrum

Bitcoin’s capital market should be designed from first principles because its final settlement does not require trusted third parties. Final settlement of the US Dollar has counterparty risk because deposits are considered a liability on banks’ balance sheets. Holders of US Dollars would rather face the US government as a counterparty rather than banks, so they prefer to purchase US Treasuries with their deposits. Either way, the final settlement has counterparty risk. Additionally, the US Dollar itself depends on a single nation and has a single entity controlling monetary policy in a discretionary way; bitcoin avoids both of these risks. Let’s take a look at Bitcoin’s risk spectrum.

Bitcoin Risk Spectrum

The first point (illustrated) on Bitcoin’s risk spectrum is bitcoin held in cold storage. The analogy commonly used for cold storage is a gold bar held in your hand. There is no counterparty risk; the risk is its storage and security, much like if you had possession of physical gold. Skilled storage and security practices make loss less likely, and the advent of robust multisignature solutions further reduces risk. Private key management anchors the bitcoin capital market much like the timeliness and consistency of the US government paying back its debt obligations anchor the US Dollar’s capital market. The expected return on cold storage bitcoin is at best zero and is actually negative if you consider that storage costs and on-chain transaction costs are non-zero.

I am proposing that the second point on Bitcoin’s risk spectrum should be LNRR, the Lightning Network Reference Rate. Routing fees earned on bitcoin staked to Lightning payment channels can be expressed as an interest rate. The rates received on the payment channel or node level can be hashed and cryptographically provable. Node operators can opt-in to publish realized interest rates on their capital. If a consensus can be reached on an interest rate calculation protocol, capital providers can publish interest rates in an open and transparent way. Positive interest rates will attract bank-like entities that believe they can earn positive return using effective payment channel management and security techniques. Some bitcoin previously held in cold storage will seek the income attainable in Lightning Network, the first ever example of an opportunity cost tradeoff in bitcoin that doesn’t require additional counterparty risk. Bitcoin staked to Lightning is the most unique income producing asset in all of monetary history: income with zero counterparty risk. The historical implications of this on capital markets are tremendous.

A huge leap in risk exists between the second and third point on Bitcoin’s risk spectrum. The first two points, as we have established, have various security and management risks but no counterparty risk whatsoever. Real world lending of bitcoin has genuine counterparty risk, whether using exchange-based lending platforms or other forms of direct lending. In theory, these rates of borrowing should be higher than LNRR, and capital providers could use LNRR to make relative value decisions between bitcoin leasing via Lighting and off-chain bitcoin lending. Any real world lending will not have bitcoin’s blockchain as security. Lenders will need strong contracts in jurisdictions with strong rule of law to ensure repayment of capital, just as they do with fiat currencies. Complete loss of principal remains.

4. The Lightning Network Reference Rate

I present a three part proposal for Lightning Network node operators. The first and most crucial part of the proposal is a node-level calculation standard for the accrual of satoshis. The Node Accrual Rate (NAR) is offered as a formula to calculate the profitability of an individual Lightning node, expressed as an annualized interest rate.

The second part of the proposal is to convince Lightning node operators to disclose their NARs to each other. Transparency and financial disclosure are core tenants of capital markets, and the disclosure of NARs could correspondingly push bitcoin forward on its path to becoming a more robust asset class.

The third and final part of the proposal is to advocate a framework in which NARs across the network can be aggregated, averaged, and reported as one rate called the Lightning Network Reference Rate (LNRR). LNRR can pave the way for a world of relative value calculations and be instrumental in the pricing of off-chain bitcoin lending.

This is not a proposal for any changes to Lightning Network itself, nor a call for all nodes to share fee accrual data. Nodes will elect for themselves whether or not to share data, and most will likely choose not to do so. The formula is merely a suggestion for developers trying to capture the economics of payment routing.

The Time Value Layer

The Lightning Network sets up a framework from which we can calculate the time value of bitcoin. Interest rate calculations must have three known inputs: principal, income, and time. In Lightning terms, a node opens channels with other nodes and broadcasts the channel opening, essentially locking up principal for a predetermined amount of time. Assuming incoming channels are also opened to the node, the node is now positioned to route payments and charge fees for doing so. These routing fees can be considered income. The ending calculation can be expressed in many ways, but through time node participants will elect standards around which to coalesce. This proposal is a starting place for the discussion around these standards. If multiple standards emerge, I would view this as a positive development because competing calculation standards would foster deeper study of Lightning Network routing economics.

Lightning Network is also an optionality layer. Optionality is relevant to Lightning because it serves to offset one of the primary risks undertaken by Lightning node operators: malicious counterparty risk. Nodes carry the risk of their channel counterparts broadcasting a previous channel state, but this risk is theoretically negated by embedded call options which become executable upon malicious activity. The settlement optionality simultaneously serves as a security enforcement mechanism and a velocity accelerant.

Proposal #1: Node Accrual Rate

I propose the idea of a Node Accrual Rate (NAR) for individual Lightning nodes that desire a standardized method for calculating their realized interest rates. Nodes should be able to automatically calculate their rate of return on capital allocated to facilitate Lightning Network payment routing. Rates can be calculated by querying observable data available in their lnd, c-lightning, or Eclair clients. The following is a proposal for one way to calculate the rate using a generic formula for compounding interest and adapting for block time. The node data can be sliced and diced dozens of logical ways, and I look forward to many counterproposals that are sure to include innovative ways to capture return data.

NAR = [(p+f)/p]^(52,560/n)-1

Let n = the measurement period, expressed in number of blocks, suggested minimum value of 100

Let p = node’s average balance held in channels over the measurement period, expressed in satoshis

Let f = total routing fees earned by the node over the measurement period, expressed in satoshis

52,560 is the approximate number of blocks per year to normalize NAR as an annualized rate


The suggested 100 block minimum measurement period is arbitrary but matches the minimum block time before mining rewards become spendable. Said another way, your Lightning node should be active a certain number of blocks in order to reasonably measure an annualized rate of return. I believe this minimum can be increased to cover at least one full difficulty adjustment period of 2,016 blocks once routing activity becomes more commonplace. A longer minimum measurement period would make for higher quality and less noisy data.


The average balance of a node throughout time can be measured a multitude of ways. Striking channel balances upon each new block confirmation and then averaging these amounts over the measurement period could be a clean and impartial way to determine p.


Lightning Network node operators are already sharing f with each other. I’ve seen numerous “day_fee_sum” screenshots on Twitter with positive integers next to them. Accelerated adoption of the Lightning Network over the past few months brought time value to bitcoin in a trustless way, and nodes are earning sats as a result. Node operators already sharing f with each other will soon be calculating and sharing their NARs as well.

Proposal #2: Disclosure of NARs

Lightning node operators currently volunteer information about collecting routing fees, managing payment channels, and other emergent routing techniques. In a similar way, I anticipate and strongly encourage nodes to volunteer their NARs. Sharing NAR data is an easy way to display profitability to other capital market participants. The exchange of profitability information is a foundational tenant of capital markets; the widespread exchange of NAR data between nodes would accordingly bring long term health to bitcoin’s capital market. Node operators are already disclosing the small amount of sats they’ve earned by routing payments through the Lightning Network, leading me to believe that such NAR exchanges will be commonplace for nodes motivated by profit or by transparency. Some nodes will look to attract capital in order to leverage their newfound skill set, even though most nodes will not be motivated to share data. Some nodes will be dishonest about their NAR, and the market will have to identify fraudulent disclosures just as forensic accountants dissect every disclosure from publicly traded corporations.

Advertising profitability, even if unaudited, will attract capital looking for return. Example: a Lightning node with sufficient capital and well positioned inbound and outbound payment channels earns a NAR (annualized return) of 0.25%. Funded with 10 million sats (0.1 bitcoin/~$400), the node earns about 957 sats (~$0.04) in one difficulty adjustment period (2,016 blocks/~2 weeks). The implications of being able to earn sats without relinquishing control of private keys is truly a monumental arrival for bitcoin in capital market terms, no matter how tiny the amount of interest may seem.

The node operator can choose to leverage its profitability by advertising a historical rate of return. The node from the example promises depositors a rate of return of 0.15% because a 0.25% return on routing would ensure a positive profit margin. The investor takes counterparty risk because the node could instantaneously exit scam with the depositor’s money or simply fail to deliver on its promise to pay a rate of 0.15% on invested capital. The node, however, is instead motivated by creating a strong reputation as a counterparty and repays all depositors the promised rate to establish creditworthiness and increase the potential for additional deposits. The routing income accrues to the node in a trustless way, but the depository relationships occur entirely off-chain in trusted counterparty situations. The bitcoin era Lightning Network bank, without barrier to entry, available to anybody with the appropriate hardware and software, has arrived. Many will route, profit, succeed, raise deposits, fail, mislead, overpromise, and default, all essential components to a healthy and functioning capital market.

Proposal #3: Lightning Network Reference Rate

Lightning Network transitions bitcoin to a more capital market oriented asset. Hashed Timelock Contracts (HTLCs) combine some of the protocol’s most powerful features into a standardized financial agreement with defined optionality and expiry, allowing participants in the Lightning Network confidence to transact bitcoin without the burden of continuously auditing individual clauses. In theory, the HTLCs in Lightning Network provide bitcoin with its own native risk-free asset (aside from cold storage and HODLing, see Risk Spectrum section), which is a theoretical term in traditional finance used to describe the asset bearing the lowest possible risk within an investment universe. The US Treasury’s obligations carry this label in US Dollar capital markets, and like bitcoin held in Lightning payment channels, have materially less risk than other counterparties. Bitcoin held in Lightning payment channels should serve as a low-risk alternative to off-chain lending and can be used as a reference transaction by which to measure risk premium.

If Lightning node operators around the world disclosed enough NAR data to establish a statistically significant average, this average rate could serve the purpose of offering the bitcoin capital market an accurate measure of low-risk time value. Example: hundreds of nodes disclose NARs, and a cluster of rates is observed around 0.18%. The rate can be a cluster, average, or median of publicly disclosed NARs taken each block or daily, and the end result would be a reference rate widely disseminated to all Lightning Network participants. The Lightning Network Reference Rate (LNRR) can be a very powerful signal that bitcoin has a native time value, a rate that risky off-chain lending should theoretically exceed. If LNRR is equal to 0.18%, an exchange offering 6% on deposits is actually offering a rate of LNRR+5.82%. LNRR represents the time value of the transaction and 5.82% represents its risk premium.

Investors can lend money to the US Treasury at 2.5%, or they can lend to investment grade (IG) corporations at Treasuries plus 1% or junk grade (HY) corporations at Treasuries plus 4%. Investors don’t look at the IG and HY companies as investment opportunities yielding 3.5% and 6.5%; they strip away the Treasury component (time value of the US Dollar) to determine relative value between credit spreads. The Lightning Network Reference Rate can and should serve a similar function in bitcoin capital markets. Exchanges wouldn’t be offering deposit rates at 6% or 8.5% but instead at LNRR+5.82% or LNRR+8.32%.

The Goal is Reserve Currency Status

Reserve currencies need deep and liquid capital markets. Investments denominated in bitcoin exist only on a small scale, largely because bitcoin is still mostly a commodity and costs resources to store and use as opposed to other assets that accrue positive time value. Lightning Network officially switches the equation for bitcoin but is still a nascent technology. For bitcoin to continue its journey toward becoming a world reserve currency, theoretical financial frameworks such as time value, risk premium, and optionality have to evolve but without relying too heavily on legacy ideas and ideals. The primary reason for this proposal is to offer an opportunity for bitcoin to capture relevant characteristics from traditional capital markets and transform them into native and emergent bitcoin financial theory.

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Nik Bhatia

bitcoin-native financial theory, adjunct professor of finance and business economics @USCMarshall