The Lightning Network (LN) is a scaling solution based on the Bitcoin blockchain, also called a Layer 2-solution. It is a decentralized network using smart contract functionality in the blockchain to enable instant (micro)payments across a network of nodes. Two nodes can open a payment channel: a peer-to-peer connection through which bitcoin can be transacted. In their channel, they can transact as fast and often as they want by simply updating their private record. And when they are done, they can close the channel by settling the original on-chain transaction. Only this settlement will be visible on the blockchain. Each node can open as many channels with as many nodes as they want, forming a global web of connections. Through this web, nodes can ‘route’ payments to other nodes, even if they are not directly connected. Nodes: Source: bitcoinvisuals.com Network Capacity Source: bitcoinvisuals.com The LN has been growing rapidly in recent years. This is evidenced in part by the number of nodes and the sum of the credits in all channels between these nodes (also called the capacity of the LN). See also the relevant visuals Bitcoin Lightning Network Nodes Chart - Bitcoin Visuals and Bitcoin Lightning Network Capacity Chart - Bitcoin Visuals. 

The LN has gained a foothold worldwide with nodes on every continent. Furthermore, several CASPs have already integrated the option to send bitcoin via lightning to/from their platform. Whereas regular Bitcoin transactions are in principle completely transparent, as they are recorded in the blockchain, this is different for Lightning transactions. Lightning transactions between two lightning nodes take place off-chain, only at the opening and closing of a channel is an on-chain transaction made that reflects the channel’s beginning and end balance. Moreover, indirect lightning transactions that span multiple channels are not traceable in the blockchain. 

This raises the question whether transactions on the LN fall within the scope of the TFR. If not, we foresee a potentially undesirable shift of transactions to the LN (and possibly other scaling solutions). Specifically with respect to the LN, the TFR does not, in our view, provide a conclusive answer as to whether LN-transactions fall within its scope. According to Article 2(1) TFR the Regulation applies to transfer of crypto-assets, where the crypto-asset service provider, or the intermediary crypto-asset service provider, of either the originator or the beneficiary has its registered office in the Union. The definition of ‘’transfer of crypto-assets’’ has been set out in Article 3(10) TFR. The given definition raises the question whether units transferred on the LN qualify as transfers of crypto-assets. In our view, the TFR does not provide a conclusive answer to that question. 

Please note that this uncertainty about whether Lightning Network transactions fall under the scope of TFR applies to other layer 2 and 3 solutions, as well.