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I'm confused.

I've watched the video The Lightning Network Explained (Litecoin/Bitcoin), and read the following comments by Craig Wright:

This occurs because schemes such as segregated witness allow for the introduction of fractional reserve systems into bitcoin. [Sources: coingeek, SegWit and the Illusion of Scale]

From the video explanation of segwit/lightning it would seem that a bitcoin is required to open a payment channel and create the "IOU" that is used for the lightning transaction(s).

How can this be considered fractional reserve if there is a 1-to-1 mapping from bitcoins to payment channel balances?

It would actually seem to do the opposite and keep 3rd parties honest.

What am I missing?

Thanks.

  • If you are concerned about fractional reserve then ignore segwit and side chains... Bitcoin exchanges, gambling sites, or any other place where you deposit Bitcoins can run fractional reserve on un-withdrawn funds. Some exchanges go to extra effort to prove they aren't. – user253751 Aug 15 '17 at 5:51
10

A sidechain has its own blockchain which is coupled to the Bitcoin blockchain via a two-way peg. This allows tokens on the Bitcoin blockchain to be frozen in order to make new tokens available on the sidechain. In turn tokens on the sidechain can be either destroyed or frozen to move money back to the Bitcoin blockchain.

Lightning Network is not a sidechain. It's a second layer that builds on top of Bitcoin and uses the same tokens as Bitcoin. Channels are created by sending money into native 2-of-2 multisig addresses on the Bitcoin blockchain. After a channel is created by sending money to the mutually controlled address, the current state of a Lightning channel is stored in a pair of unconfirmed Bitcoin transactions. When one of the participants wants to close the channel, they can unilaterally broadcast the latest state to the Bitcoin network. When the exit-transaction is added to a block, the final state of the channel is executed. Alternatively, they can collaborate with their partner to close it.

Since the full Bitcoin balance of the Lightning channel is stored in the multisig address that established the channel, all bitcoins are fully accounted for. Therefore, there is no fractional reserve in Lightning Network.

  • if the payment is unconfirmed, would it be possible for the same bitcoin to be used to simultaneously open a different payment channel with another party? – CoderBrien Aug 14 '17 at 20:26
  • @CoderBrien No. Because the channel's state is stored in an unconfirmed Bitcoin transaction, neither party can use any funds that are in the channel. They are in a no man's land between the sender and recipient. – David Schwartz Aug 14 '17 at 21:58
  • Although the lightning channel use the same bitcoin token as the one on the blockchain, there is still a slight risk that a user won't be able to close its channel correctly to get back its bitcoins on the blockchain ledger, including in case of high network congestion. So the layer 1 and layer 2 tokens have the same name but slightly different properties which may cause different market valuations. – mquandalle Aug 24 '17 at 21:27
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Craig Wright's statement is fundamentally incorrect. Craig Wright is often wrong; he spews nonsense and technobabble and doesn't seem to actually understand anything.

First of all, the Lightning Network is not a sidechain. It is a network of off-chain payment channels. Since each channel is directly funded with Bitcoin and the transactions made in the payment channel are Bitcoin transactions, there cannot possibly be a fractional reserve. You aren't missing anything, the articles are simply wrong.

  • Hi andrew- actually, the video is pretty good (not nonsense like the craig wright paper). Thanks for helping me understand! – CoderBrien Aug 14 '17 at 20:21
  • Can you explain what a side chain is then? – CoderBrien Aug 14 '17 at 20:22
  • Actually... just to be clear, does the payment channel require one to commit bitcoin that cannot be committed elsewhere? (hope i'm making sense). – CoderBrien Aug 14 '17 at 20:24
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    The payment channel requires that the funding transaction be confirmed, so it is committed. Transacting within the payment channel is just creating transactions which spend the funding output and send to the participants. Those transactions are replaced with updated versions as the participants decide to pay money to each other. – Andrew Chow Aug 14 '17 at 20:32
  • Thank you so much for helping me understand! Btw now that I understand it, it sounds really awesome. – CoderBrien Aug 14 '17 at 21:02
3

While the other answers have done a good job of explaining why the statement is misleading, I want to point out that it is technically true. Again, what he said was:

This occurs because schemes such as segregated witness allow for the introduction of fractional reserve systems into bitcoin.

And that's true. You could, if you wanted to, build a fractional reserve bitcoin system on top of segregated witness. Lightning is not such a system, but anyone who wanted to could build one. (And one could imagine a system very similar to Lightning that used SegWit the same way but that permitted fractional reserves.)

As for whether this is a rational reason to oppose segregated witness, I would argue that it's absolutely not. Any powerful feature or system can be used by other people to do things that we might prefer that they not do. If the fact that it could be used to build a fractional reserve system is a rational reason to oppose segregated witness, then that it could be used to fund terrorism is a rational reason to oppose bitcoin itself.

  • Just wondering, since you could build a fractional reserve system on vanilla Bitcoin already, how does SegWit change that? – Murch Aug 14 '17 at 21:49
  • Among other things, SegWit makes it easier and cheaper to get funds into and out of such a system. – David Schwartz Aug 14 '17 at 21:56
  • @DavidSchwartz You make a good point, but I don't see how SegWit allows anything that can't already be done. At the end of the day a SegWit transaction is a transaction just like any others, no? How the data is stored is irrelevant. – Daniel Morritt Aug 15 '17 at 19:25
  • @DanielMorritt I agree that SegWit doesn't allow anything that can't be done other (possibly worse) ways. If you read the quote as imply that fractional reserve systems are impossible without SegWit then, of course, it's false. (I don't read it that way.) – David Schwartz Aug 15 '17 at 22:56
  • @DavidSchwartz Ahh OK, I read "This occurs because schemes such as segregated witness allow for the introduction" and to me it sounds like it's being worded in such a way as to imply it's not already possible. – Daniel Morritt Aug 16 '17 at 12:57

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