#36 - Hosted Channels, Growing Open Interest, Ecosystem and much more!
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🤓 What are hosted channels?
After discussing Turbo Channels, let’s cover Hosted channels, another kind of channels that seek to enhance the Lightning channels UX while staying in line with the specification and mitigating the required tradeoffs.
Not on-chain enforceable channels
The big difference between a hosted channel and a regular Lightning channel is that the former is not enforceable on-chain, simply because there is no channel opening transaction to spend from.
That’s right, hosted channels are not opened using a Bitcoin transaction. There is no funding transaction. Instead, there is a certain level of trust between the client and the host of the channel.
Indeed, the two participants of a hosted channel are not equal:
the host provides the channel, with liquidity on their side,
the client enjoys access to the Lightning Network using the Host’s channel(s) and can receive right away because the funds are on the host’s side.
In reality, the money never actually leaves the host’s side, even after some transactions occur. Hosted channels are therefore a certain type of custodial channels. Once some satoshis have been received on the hosted channel (and the host therefore owes them to the client), the client must trust the host not to exit scam with the funds. So what’s the matter? Why are hosted channels worth mentioning?
Trust is a spectrum
How are hosted channels different from custodial wallets?
When you use a custodial wallet such as Wallet of Satoshi, the wallet provider takes care of everything. Your balance says 10,000 sats, but in reality the sats are in one of the wallet provider’s channel. If you receive a payment, it’s actually the wallet provider that receives it and increment you balance accordingly. When you send a payment, you just ask the wallet provider to send a payment on your behalf, and it is the wallet provider that will calculate the route to your recipient and actually process the payment. There is therefore a lot of trust between you and the wallet provider, and a lot of ways in which this trust can be abused.
Imagine that you want to receive a payment. In a completely custodial wallet, the invoice is actually crafted by the wallet provider. When the payment completes and the funds are received, the wallet provider should increase your balance of the amount of the payment. But they could very well tell you that the payment failed, let your balance as is and pocket the funds for themselves. That’s effectively stealing from you, and you have no way of detecting it. Even if the person that pays you insists on the fact that the payment went trough, showing you that they have the preimage, you have no way of telling who tells the truth between them and your wallet provider, because the invoice was generated by the wallet provider and you therefore do not know the associated preimage.
When you use a custodial wallet that leverages hosted channels (such as Simple Bitcoin Wallet (SBW) for example), things are a bit different but the UX remains the same: you’re able to receive and send sats on Lightning almost for free. You must pay routing fees, but the channel opening is free, since no Bitcoin transaction is published. This contrasts with non custodial solutions using Turbo Channels (such as Phoenix), where the user pays for the channel opening.
The sats that are displayed as yours on the app are still on the side of the host, so its equivalent to the situation with Wallet of Satoshi. But because your wallet acts as a light Lightning node, receiving and sending payments is much more private and secure.
Let’s consider again the case where you want to receive a payment. This time, you are the one crafting the invoice, not the wallet provider. Therefore, the wallet provider cannot receive the payment and pretend like it didn’t, because it needs to get the preimage from you in order to unlock the HTLC from the previous hop.
On the other hand, if you send a payment, the only way for the host to unlock your HTLC is to give you a valid preimage for the payment, like in any regular payment routing. It can therefore not cheat on you by pretending the payment worked while they kept the funds to themselves.
Another interesting aspect of hosted channels compared to regular custodial channels is privacy. When you send a payment using a custodial wallet such as Wallet of Satoshi, the wallet takes care of calculating the route and therefore knows everything about the payment, from the amount to the destination. With hosted channels, the route is calculated locally by the client, and the host only acts as a hop along the way (but please note that the host knows that the payment comes from the client).
Finally, because things are conducted on a hosted channel as they are on a regular channel, the host and the client exchange cross-signed channel state data (the hosted channel equivalent to commitment transaction). The user therefore has some kind of cryptographic proof regarding what the host owes them, which is absolutely not the case for traditional custodial wallets.
TL;DR: with hosted channels, if a user gets fucked, they can prove it.
Finally, hosted channels exhibit an interesting property. Although they are custodial, they can be provided by other entities than the wallet provider. You can for example have a hosted channel where fiatjaf is the host, inside your SBW app. It decorelates the channel and funds custody from the app and the information it displays. In my opinion, this can add strong guarantees and funnel the emergence of a wide, reputation-based hosted channels marketplace.
Going public
One last interesting thing with hosted channels is that they can be publicly announced to the network. Other peers can therefore use your hosted channel without additional trust. In fact, they don’t even need to care whether the channel is a hosted or a regular one: in case of a problem, their funds would not be affected.
“A hosted channel requires trust between two peers of the network at the protocol level, but then, if the channel is public, other peers on the network can leverage this channel without additional trust.” Anton Kumaigorodski
Final thoughts
Hosted channels are custodial channels. They are not enforceable on-chain. But among all the custodial solutions, they appear to me as the least worst. They allow to onboard new users on Lightning at a very low cost, since it is not necessary to actually publish a channel funding transaction. Of course, they require much more trust than Turbo Channels, but in the same time they fix one of the main issues of this kind of channels: the upfront cost required to join the Lightning Network.
To Go Further
Check this very insightful discussion between Matt Odell, Anton Kumaigorodski, fiatjaf and Eric Sirion during the episode 45 of Citadel Dispatch (especially from 13:30 to 28:00).
📈 Open interest in BTC perpetuals is growing in a neutral funding environment
Leverage is once again picking up in the perpetual swaps, evident by the growing open interest in the bitcoin perpetuals.
The open interest in the bitcoin perpetuals has grown from 186,000 BTC on Dec 5th to 226,000 BTC on Dec 20th, as leverage once again is picking up in the market.
Binance’s USDT margined perpetual have seen the sharpest OI growth in the last weeks, with the instrument seeing its OI growing from 40,000 BTC to 62,000 BTC since Dec 5th.
The OI growth on Binance has been accompanied by neutral to slightly below neutral funding rates, indicating that the market is less exposed to brutal long squeezes analogous to what we saw on Dec 4th.
Growing open interest in the stablecoin margined BTC perpetual caused havoc for shorts in late July, as underwater shorts were liquidated during a memorable short squeeze.
A similar squeeze is not out of the picture now. However, back in July, we had seen prolonged negative funding rates on Binance for well over a month. The funding rates in recent weeks indicate that short traders have been slightly more aggressive than long traders, but we are still very far from the aggressive shorting seen this summer.
Get full access to Arcane Research’s Weekly Update here!
🌱 Ecosystem
💥 The newest THNDR game is here! Have fun and grab some sats, seems like a fair deal!
⚒️ A much welcome initiative from HRF and Strike, especially in times of debate around the funding of FOSS developers! They are incentivising, with up to 3 BTC bounties, the implementation of crucial wallet features for global Bitcoin users:
a Lightning Tip Jar for receiving Lightning payments privately,
a stabilized Lightning that would enable anyone to “peg” an amount of bitcoin to U.S. dollars without needing an exchange or another token,
and a e-cash arrangement to enable anonymous bitcoin usage for users.
💰 Looking for funding to build your Bitcoin / Lightning company? Be sure to contact the amazing investors listed below. And check out this article - “Tldr; high time preference fiat thinking crypto vc’s gonna get wrecked”.
👀 Hugo Nguyen woke up and chose violence. A very informative thread debunking Ethereum Rollups! A must read after our primer on this topic.
Hugo Nguyen @hugohanoi
So after all the years of meandering, of wanting to be the “world computer”, Ethereum comes full circle, back to Bitcoin’s tried and true architecture, with tons of complexity added in the process. Are "rollups" Ethereum's acceptance of defeat? 37/⚡ Bonus
🎅🏻 Thanks BitMEX for the walk down Bitcoin memory lane!
😆 Sane reminder that crypto can hurt
🚀 The central banker of the year
✅ Yes you should
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