There are two possible ways of answering this question: with a brief and general answer or with a detailed and elaborated one. Let’s go through the general answer before elaborating.
The General Answer
First, let’s quickly recall the meaning of these concepts:
- Inbound liquidity is the number of satoshis that you’re able to receive over a lightning channel;
- Outbound liquidity is the number of satoshis that you’re able to send over a lightning channel;
So, in general, you’re going to need inbound liquidity to be able to receive a payment, and you’ll need outbound liquidity to be able to send a payment.
A Detailed Explanation
But, if we take a deeper look, we’ll see that different types of users need inbound and outbound liquidity for different purposes, so the real answer to why you need inbound and outbound liquidity is that it depends on what you’re doing on the lightning network.
The lightning network is mostly used by
Let’s go through all of them and understand why each one of them needs inbound and outbound liquidity for.
Consumers can be considered regular users of the lightning network. If this network succeeds and becomes a widely adopted payment method across the globe, then paying for goods and services would be the most common use case for lightning.
This type of user will mostly be spending bitcoin, so they will need outbound liquidity in order to be able to send payments to the merchants.
If you’re in El Zonte, for instance, you can use the lightning network to pay for pupusas, accommodation, and surf lessons. If you don’t have enough outbound liquidity, you won’t be able to pay for all that.
But this doesn’t mean that a consumer won’t need any inbound liquidity. If you go to a restaurant that doesn’t accept bitcoin with your friends, you can pay for everyone’s meal with fiat money and have your friends send lightning payments to you to cover their share of the bill. In this situation, you’ll need to have inbound liquidity to receive those payments.
On the other end of a consumer paying for a product or service with lightning, there will be a merchant that is going to receive that payment.
Let’s pretend that you are the owner of a beachfront restaurant in El Zonte. Suddenly lots of bitcoiners start popping by and asking if they could pay for their meals using bitcoin over lightning. You’re a smart person, so you decide to attend to this demand. You set up your lightning node but when bitcoiners try to pay you all payments fail.
You now realize why you need inbound liquidity for. If you want to receive payments over the lightning network you’ll need channels opened with peers that can move satoshis from their side of the channel to your side of the channel.
From time to time you’ll also need to pay your bills and employees, and hopefully, if you’re profitable, move some of those satoshis on lightning to on-chain cold storage. This is why merchants also need outbound liquidity. Maybe not as regularly as they need inbound liquidity, but still, they need it. This will happen naturally as people pay you.
The lightning network is a big web of nodes. When you make a payment over the lightning network, what’s really happening under the hood is that your node tries to find a path of connected nodes from your node to the receiver’s node that is suitable to move that payment. But what makes a path suitable?
A path is suitable if there is enough liquidity to accommodate the size of your payment. If you’re sending 1000 satoshis, you’ll need to find a path of connected nodes with at least 1000 satoshis of inbound liquidity and outbound for every hop your payment goes through.
If there’s no path connecting the nodes with enough liquidity, then the payment can’t be made. Sum this up with the fact that nodes can charge fees to forward payments and we have an economic incentive for nodes to specialize in the activity of forwarding payments through the network. Lightning nodes specialized in this are called “Routing Nodes”.
So if your goal in the lightning network is to be a routing node, then you’ll need both inbound and outbound liquidity. Without inbound liquidity, your node won’t be able to receive payments to be forwarded. And without outbound liquidity, your node won’t be able to forward the payments.
- You need outbound liquidity to be able to send payments over the lightning network;
- You need inbound liquidity to be able to receive payments over the lightning network;
- Different people use the lightning network for different reasons, so in the end, they need inbound and outbound liquidity for different reasons:
- Consumers need mostly outbound liquidity to be able to pay merchants. They’ll also need inbound liquidity when receiving payments, but that won’t be happening so often;
- Merchants mostly need inbound liquidity so they can receive payments for the services and goods they provide. Outbound liquidity will be needed to pay bills and employees. If you’re a merchant, you can read more about how to run an effective merchant lightning node here;
- Routing nodes need inbound and outbound liquidity to be able to offer efficient routing through the lightning network. Also worth noticing is that over time a “consumer” will likely naturally generate inbound through spending, and their node will eventually become a routing node naturally. This can be thought of as a “low-time preference routing node strategy” and you can read more about it here.