4 min read

Creative Destruction Through Payment Channel Networks

This post provides an overview of the fundamental building blocks of payment channels and illustrates their value proposition for improving interoperability, scalability, and democratized access to payment systems.
Creative Destruction Through Payment Channel Networks
Photo by Felix Mittermeier / Unsplash

Every economic development is based on the process of creative destruction. The term was introduced and popularized by Joseph Schumpeter, one of the most influential economists of the early 20th century.

“Prophet of Innovation” by Thomas K. McCraw

In his works, he characterized innovation as the determining dimension of economic change.

He reasoned that technological innovations often lead to temporary monopolies which allow for exceptional benefits, only to be soon eroded by competitors and imitators. According to him, these temporal monopolies are necessary to incentivize businesses to develop new products and technologies.

Monopolies in online payment networks

At present, the biggest monopolies for online payments are built around large credit card processing companies.

The largest credit card networks are VISA and MasterCard. In Europe, the credit card payment market is essentially divided in two, with Visa Europe Services Inc. taking about 60% of the market share and MasterCard Inc. taking the remaining 40%.

The omnipresent model of a four-party payment structure, image source: saniyayadav.com

4-party payment structures

Not taking into account the credit card network as a separate entity, payments made through credit cards are carried out in a so-called four-party system. That involves

  1. the payer (cardholder),
  2. the payee (merchant)
  3. the issuer and
  4. the acquirer. 

The issuer and the acquirer are payment service providers that operate on a credit card network.

3-party payment structures

In analogy to the 4-party system, there is also the three-party system. That means that the payer and the payee use the same payment service provider. 

One famous example of such a provider is the American company PayPal Inc.

The infeasibility of micro- and p2p-payments

While the Internet has democratized access to knowledge, it has not yet democratized the flow of payments.

Existing structures not only limit transaction partners to people who are “banked“, but also prevent the inexpensive implementation of micropayments.

For low-value goods, the cost-effectiveness of payment is a key problem: conventional methods are unsuitable because the costs of payment processing often exceed the value of the goods.

As such, cost-effective ways of implementing micropayments usually require the involvement of additional parties in the payment handling process (gatekeepers), the prior provision of funds (prepaid), or the bundling of several payments into one.

The birth of novel payment rails

What all these workarounds have in common is that their inflexibility prevents them from being smoothly integrated into the existing Internet infrastructure.

Consequently, a solution can only originate from an internet-native type of payment process. All payment processes, as well as the underlying infrastructure, must operate on a purely virtual, protocol basis.

The Lightning Network, a scaling solution for blockchains, has paved the way for this kind of evolution.

A democratized model of payment flows

By design, the new payment network is based on a decentralized, democratized model of payment flows. This instant and microtransaction-compatible value transfer is enabled by the concept of a bidirectional payment channel.

Using payment channels on blockchains, recurring payment parties can pay each other at zero cost an unlimited number of times without third-party involvement. This level of transacting greatly exceeds the capabilities of existing payment networks.

The lifecycle of a payment channel, source: d11n.net

Even if two transaction partners have not established a direct channel with each other, they are able to pay each other through one or more intermediaries who forward the payment (for a microtransaction fee) from the payer to the payee.

Visualization of the Lightning Network as of January 24, 2022

In fact, this technology is gaining momentum. As of January 24, more than 80,000 public payment channels have been established and around 18,000 nodes have been booted into existence. That’s a staggering 138% growth in public payment channels and a 112% growth in nodes in 2021 alone.

New technological opportunities await

But that’s just half of the story: the miniaturization and low barriers to adopting the technology allow any smartphone user to operate private payment networks with others, thereby creating new structures of how people can pay each other in the digital realm.

It does not require companies to process the payment and reflects the interconnectedness of autonomous participants.

In addition, the existing p2p infrastructure unlocks new opportunities for the emergence of novel applications that leverage the underlying capability to exchange data in a censorship-resistant manner.

Changing the world of value transfer

If Joseph Schumpeter were alive today, what would he say about these dynamics? Would he perceive an alternative payment network as the result of a creative destruction process? Might he even assign it the status of a technological basis, his beloved Kondratiev wave?

History has taught us the power of innovation.

Even major players in the industry aren't always equipped to deal with it appropriately. Likewise, they have difficulty predicting what unprecedented innovations will emerge.

To what extent the process of creative destruction of payment channel networks will take us continues to be a fascinating one.

The rise of lightning has been meteoric. This blog post is the starting point for our new series of articles on lightning technology and its practical applications.

It's a new paradigm for the way we pay, communicate, and exchange value over the internet.

But what does it mean for you and your business?

Stay tuned!