Hedging, Yield and Lightning Network Nodes
In the last six months, the Lightning Network ecosystem has expanded rapidly, making Bitcoin accessible to anyone with an internet…
In the last six months, the Lightning Network ecosystem has expanded rapidly, making Bitcoin accessible to anyone with an internet connection. You can tip Twitter users for witty tweets and dank memes, stack Bitcoin in online deathmatches, and even stream Bitcoin to your favourite podcasters straight from your wallet. All of this is enabled by the Lightning Network, which has become an inevitable part of Bitcoin’s future. This network does not rest solely on the shoulders of a single titan, but is distributed amongst plebs, professional routers, and businesses all running Nodes. Node operators are rewarded financially for routing transactions, with some nodes earning millions of Satoshis each month in profit.
As the Lightning Network(LN) matures, professional node operators and businesses will need ways to protect the Bitcoin they dedicate to LN channels from volatility. For many, that means deciding how to run their business or operation. Whether they are a hedge fund betting on a higher Bitcoin price, or a Bitcoin business that manages its exposure to volatility, or even a hobbyist routing node operator, it is imperative to know how to hedge risk. Since the concept of hedging is unfamiliar to many, this article will briefly cover what it is, who does it, and how to earn yield from it. We’ll also talk about how the Bitcoin price impacts LN node operators and how they can manage risk during events such as forced channel closures.
What is hedging?
Hedging is a method of risk management that allows an asset holder to offset losses by taking an opposite position in that asset or investment. Essentially, it is a form of protection from loss. A number of instruments can be used to hedge, including short sales, futures and perpetual swaps.
To some, it might seem outrageous to consider hedging your risk or selling some of your Bitcoin. But for others, it’s a necessity to protect themselves from Bitcoin price drops or even as a source of yield.
As an example, traders may need to open positions in opposing market directions to reduce the risk of market swings. Businesses with currency exposure may need to lock in the fiat value of Bitcoin to cover expenses in fiat. Essentially, any individual, business or service that doesn’t only operate in a single currency will feel the effects of a BTC price drop. Hedging allows businesses to cover any future USD costs while being able to hold their bitcoin until they need to sell it.
For some, hedging, using perpetual and traditional futures contracts, can even be a source of yield generation. By specifically taking short positions, the market pays a premium to hold these derivative contracts. Using a perpetual swap, users can earn interest every funding window if they are short (more on this later).
Hedging as an LN Node Operator
What about the Lightning Network node operators? Do they have to protect themselves? If you run a public routing node, your idle bitcoin may be used as liquidity on the Lightning Network. By opening channels and dedicating liquidity to other nodes, anyone can send payments through the network using your liquidity, rewarding you with a routing fee. When the Lightning Network grows, routing node operators may earn a lot of Bitcoin through routing fees. However, node operators may still have fiat-denominated hardware costs, hosting, electricity, and other expenses involved in running the node. Therefore, until Bitcoin becomes the world’s primary currency accepted by every business and government in the world, then the operator of the node will have price risk to offset.
Hedging is a defensive strategy that is designed to protect profits. Future routing node operators may hedge bitcoin in their nodes to minimize loss in USD terms, as well as earning yield on their Bitcoin, particularly with perpetual swaps.
Traders taking a short BTC position will often receive a premium for holding their position. Kollider’s perpetual contracts, for example, allow you to earn interest every hour when the funding rate is positive. The interest you earn is determined by the bullishness of the market. When traders are predominantly bullish and taking long positions, long traders pay funding to short traders. In some cases, taking short positions can be very profitable. Kollider’s Alpha testers achieved annualised gains of 12.81% on short positions¹. However, annualised interest rates can reach as high as 80%. At one point, Bitmex had a funding rate of 1% a day for BTCUSD.
Earning yield by shorting isn’t risk-free. There’s a chance that a short position may pay funding to a long position if the funding rate changes. In some cases, a highly-leveraged position may need to be closed if there isn’t enough margin, leading to a liquidation of the position.
Hedging forcefully closed Lightning Channels
Let’s look at a specific hedging example for a routing node operator. When another node stops responding, node operators sometimes have to forcefully close channels. If you’re unlucky, another node might force close your channel. If you own 50% of that channel, it’s effectively locked during the force close.
Force closes can take a while, sometimes even two weeks. As a result, the node operator has an issue where they can’t maintain a ratio of on-chain Bitcoin to Bitcoin on the Lightning Network and lose out on any potential routing fees they might have got from that channel.
In this scenario, the node operator opens a short position on Kollider that controls the same amount of the forced-closed channel on their side. For example, if a channel of 10,000,000 Sats was closed of which 5,000,000 was theirs, then they would open a short position controlling 5,000,000 Sats. Thanks to leverage, the node operator can be more capital efficient and doesn’t need to use 5,000,000 Sats to open the position, so a 5,000,000 Sat position can be opened for a much smaller margin amount.
In addition to protecting their locked funds from any Bitcoin price drops, where they would otherwise be unable to sell that locked Bitcoin, they can make up for lost routing fees by earning yield from their short positions if the funding rate stays positive.
How to hedge
In the above example, a channel was forcefully closed with 5,000,000 Sats of the node operator’s funds being locked. Those Bitcoin cannot be moved in order to sell if there is a price dip, nor can that channel earn the node operator routing fees. Let’s look into how a node operator can hedge their closed channel and earn yield in the meanwhile.
An operator could open a SHORT BTCUSD position on Kollider using 5,000,000 of their Satoshis, but that is not capital efficient, and they may not have 5,000,000 Satoshis spare. This is where leverage and required margin come into play.
Leverage is a reflection of the amount of funds required to open a position in comparison to the size of the position that the operator wishes to open.
Required Margin is the amount of funds required to open the position. Required Margin = Position / Leverage
Assuming the Bitcoin price is $100,000 and the node operator wants to open a short position of roughly $5000 (5,000,000 Sats) using 5x (1:5) leverage, then they would require an initial margin amount of at least $1000 (1,000,000 Sats). The higher the leverage, the less margin required but, the higher the risk of liquidation if the market moves against the position quickly. However, with the speed of the Lightning Network you are able to update your margin balance much faster than ever before, allowing for higher use of leverage if needed.
By opening a short position equivalent to the 5,000,000 Sats locked in the forced-closed channel, the node operator is effectively locking in the dollar value of what they cannot access. Meaning, their Bitcoin is protected if the price decreases in dollar terms.
By creating a short position, they are also able to earn interest or yield when the funding rate of the perpetual is positive. On Kollider, this funding window happens every hour, meaning while hedging the funds locked in the forced-closed channel, the position could be earning 3.5 basis points per day or 0.035% (12.81% annualised). It’s important to note, that while mostly positive, funding can change according to the dynamic of traders on the platform and even how the exchange structures their funding.
This example above is a simplified approach, hedging out just the amount locked in a force closed channel for a lightning node. To make the hedge more complete, you might wish to also hedge the amount used to open the position, however this was outside the scope of the article. For more information on hedging or hedging guidelines, please contact us.
Hedging is now a far more capital-efficient endeavour than it has ever been thanks to the Lightning Network. Hedging on the Lightning Network is faster and more cost-effective than on other systems because margin can be managed more finely without leaving all funds on the exchange due to its speed and cost-effectiveness (If you’re interested in knowing what else Lightning improves for traders, see our previous article: ‘Are you using your capital efficiently?’).
As a risk management tool, hedging is crucial for Bitcoin adoption, and therefore, Lightning adoption as well. Lightning Network node operators, in particular, can protect themselves by hedging Bitcoin locked in forced closed channels. In some cases, hedging might allow non-profitable channels to remain open and improve network interconnectivity if the bitcoin in those channels are hedged and earning funding.
One of Kollider’s goals is to provide hedging and risk management tools to anyone looking to get into bitcoin, especially anyone diving into the Lightning ecosystem. Please contact us if you want help thinking about how derivatives can be used to protect against irrational markets, or if you need hedging tools for your business.
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¹ As a result of the limitations on orders, margin, and participation, Kollider’s Alpha stage funding rate does not accurately reflect market dynamics.