Bitcoin as a Medium of Exchange¶
You often hear money referred to as currency, that is, the movement of money in exchange for goods and services -- this is money as a medium of exchange. Buying a pizza or a coffee, selling a car, all are examples of using money as a medium of exchange.
This is an important area where Bitcoin has a distinct advantage and a perceived disadvantage compared to traditional forms of currency such as gold and silver coins. This is also an area where fiat, for all its faults, has proven superior to gold. Simply put, using fiat payment rails for small purchases is often more usable than any alternative. Importantly, this perceived advantage of fiat as a medium of exchange hides the fact that those seemingly quick and easy payments are sitting atop an outdated and painfully inefficient system of final settlement.
Final Settlement¶
Money as a medium of exchange for small payments is very different than final settlement. Bitcoin is unparalleled in its ability to perform final settlement. As a digital money, Bitcoin is extremely advantageous in that it can be transacted anywhere on earth in any arbitrary amount. You don't need to look for exact change, and you don't need to mail a check. With Bitcoin you send a transaction and wait for final settlement. The ability to attain final settlement anywhere on earth in any amount and without any trusted intermediaries or authority is unprecedented, and is why Bitcoin -- if it is true -- is the most superior form of money to ever exist. This is also why Bitcoin may inevitably become the money of international settlement.
However, because Bitcoin is fully decentralized and trustless, relying on transaction fees and block time, this poses a perceived disadvantage; you must wait for new blocks in order to reach final settlement. This wait plus transaction fees makes Bitcoin seemingly impractical for small purchases such as a cup of coffee. Or rather, trying to achieve final international settlement for the purchase of a cup of coffee is quite the overkill.
Neither gold nor fiat provide final settlement for a cup of coffee. Gold lends itself to a system of credits and typically relied on a bimetal monetary system where silver coins acted as a medium of exchange. Fiat relies on outdated banking cores, and in practice takes weeks or months for something as simple as a cup of coffee to reach final settlement. The exception to this is cash on hand, promissory notes, which reach final settlement the moment two trusted parties transact. Cash payments are quite efficient but must be done in person, and require trust (trust in the fiat currency itself, and trust that the promissory note in question is not a counterfeit).
There is no known completely trustless medium of exchange, that is, not until Bitcoin over the lightning network.
Lightning Network¶
Bitcoin, like the Internet itself, offers a layered architecture. Final settlement is guaranteed on the base layer, and payment networks such as the Lightning network are built on top of the base layer. You can put some Bitcoin into a lightning channel through a base layer transaction, and you can use that to buy your coffee in a fast and highly scalable payment network. Think of this as petty cash, like spending from a gift card, only faster and with verifiable payments.
Meanwhile the base layer is used only for final settlement. And yet Lightning offers its own verifiable settlements. It can do this because it is built on the Bitcoin network as a 2nd layer, gaining the security and stability of the base layer. Bitcoin on the Lightning network is backed by transactions on the base layer. The movement of Bitcoin on the Lightning network simply shifts the balances between owners.
E.g., if you start with 0.5 Bitcoin on the Lightning network and spend 0.1, and separately someone pays you 0.05, then your balance of 0.45 Bitcoin can be settled on the base layer. Closing a Lightning channel requires a base layer transaction. In fact, if you have an open Lightning channel, then you have a guaranteed transaction that could be made on the base layer to close that channel. That guaranteed base-layer transaction is why lightning payments can settle instantly. If you start with a guaranteed 0.5 Bitcoin, and you spend 0.1, your original "guaranteed 0.5 Bitcoin" transaction is replaced by one with 0.4 Bitcoin.
Lightning network is merely a protocol keeping track of the guaranteed transactions that could be made on the base layer. So while base-layer settlement is slow, waiting for 3 or more confirmed blocks, Lightning settlement is instant, and that instant settlement is backed by the guaranteed transaction that could be made on the base-layer.
Bitcoin as Currency¶
In practice, the capacity of the Lightning network, that is, the total amount of Bitcoin in all Lightning channels, represents the circulating supply of Bitcoin as a currency, as a medium of exchange. Because of the decentralized nature of the Lightning network, it is impossible to know how much Bitcoin is being used in private Lightning channels. However, the public (discoverable) channels have seen steadily growing adoption and capacity.
And importantly, despite the scaling limitations of settlement on the base-layer, Lightning transactions are infinitely scalable, easily handling millions or theoretically even billions of transactions per second.
Lightning demonstrates the importance of a layered architecture as well as the importance of Bitcoin's continuous development. Before there was Lightning, Bitcoin was simply not a viable medium of exchange. Now it offers the most advanced and scalable medium of exchange that the world has ever seen.