Growing interest in Bitcoin’s role as a shared public ledger for notarization and digital provenance stems from the realization that distributed consensus is a powerful weapon against fraud, perhaps making Bitcoin’s public blockchain the world’s foremost tamper-proof digital ledger. However, as we now explore, off-chain transactions threaten to undermine Bitcoin’s potential to become the ledger of all things.
Firstly, services such as ChangeTip, Circle and Coinbase can hide entire transactions from Bitcoin. For example, if Alice, Bob and Charlie are all Coinbase customers and Alice sends 30 BTC to Bob and 70 BTC to Charlie, these payments may never be recorded on Bitcoin’s public blockchain. Instead, Coinbase operates as a black box where funds move around internal databases before one day settling on the public blockchain. If Alice closes her Coinbase account, the public blockchain will correctly show that her overall balance has been reduced by 100 BTC, but it will not detail who received the funds. Thus, as a ledger, Bitcoin can no longer be relied upon as a primary source of accounting data. If Coinbase were to be hacked and malicious records inserted to claim that Alice sent 100 BTC to Terry the Terrorist, how could Alice prove her innocence?
Secondly, while payment channels open and close via regular Bitcoin transactions, all activity within a channel is hidden from public view. This presents a problem for accountants tasked with drawing up an accurate set of books. Let’s say Dan hires Ethan as a contractor for 100 BTC. Dan opens a payment channel in October 2015 and over the next few months Ethan is paid every time a milestone is achieved. These payments occur off-chain, so Dan and Ethan keep track of them in a private spreadsheet until the payment channel is closed in March 2016. Examining the public blockchain, Dan’s accountant can see there was an overall expenditure of 100 BTC towards Ethan but cannot ascertain how much was paid in fiscal year 2015 versus 2016. Similarly, Ethan’s tax adviser cannot accurately determine his tax liability for 2015 as the public blockchain does not reveal on which dates he received payments. If Dan and Ethan were to accidentally delete their spreadsheet, their accountants would be left in the dark.
Thirdly, since payment channels require manual tracking of payment updates, they introduce a moral hazard by enabling channel participants to disguise intent and obfuscate financial history. Let’s say Frankie hires her good friend George on an annual salary of 500 BTC. A payment channel is established so George can receive his monthly wages. After a year, George wins the lottery. Being good friends, Frankie and George agree to close the payment channel in such a way that there is no net change to Frankie and her balance is not reduced by 500 BTC. Despite being liable for payroll and income taxes, Frankie and George decide to not disclose this to the tax authorities because the public blockchain can only show the existence of a payment channel, not what happened inside of it, making the risk of discovery extremely low.
A counterargument can be made that technology is not to blame for accounting problems, that individuals themselves are responsible for maintaining good records. Indeed, it should be quite easy to obtain transaction records from regulated businesses like Circle and Coinbase. However, it could prove difficult to obtain complete records for Lightning transactions when they are designed to be routed through multiple payment hubs and ephemeral peers. Having to scurry around and obtain records from a smorgasbord of untrusted third-parties in an effort to reconcile off-chain transactions appears to be at odds with the vision for Bitcoin as a shared public ledger which anybody with a computer can validate.
Also consider that Bitcoin has excited proponents of triple-entry accounting because the blockchain solves the problem of how to securely store verifiable transaction records. With classical double-entry accounting, balanced books can hide fraudulent transactions. This is how in 1995 a single rogue trader was able to bankrupt the world’s second oldest merchant bank. A blockchain-based triple-entry accounting system could improve risk management by enabling a real-time view into an organization’s financial health. Moving transactions off-chain looks like a step backwards for Bitcoin at the precise moment the accounting world takes a leap forward with blockchain technology.
If Bitcoin’s future growth comes from off-chain transactions at the expense of regular transactions, the public blockchain is likely to be transformed from a ledger of peer-to-peer cash payments – as originally envisioned by Satoshi – into the backbone of a settlement network. Over time, off-chain businesses might become emboldened to introduce practices long considered anathema to many, such as rehypothecation of Bitcoins and fractional reserve wallets. Fortunately, Bitcoin is an open system so nobody is compelled to use these services and their success or failure should be largely determined by market forces. By contrast, an engineering plan which permanently binds Bitcoin to Lightning could forever change the nature and value proposition of Bitcoin as a shared public ledger. Attempting to scale Bitcoin by forcing transactions off the public blockchain could be the cure that kills the patient.