Regulators often struggle to keep pace with technological innovation, and crypto-assets are no exception. While the EU regulatory framework for crypto-assets is gradually taking shape, new blockchain-based developments still test the boundaries of existing rules. One such development is the Lightning Network: a second layer (off-chain) network built on the Bitcoin blockchain that enables a faster and more cost-effective way to make small Bitcoin transactions. With the Lightning Network, individual transactions are recorded off-chain and are only settled on the underlying Bitcoin blockchain.

This defining feature raises a concrete regulatory question, recently brought into focus by the Dutch Authority for the Financial Markets (AFM) in a question to the European Banking Authority (EBA): when Bitcoin moves on the Lightning Network, do the EU rules on crypto-asset transfers, including the travel rule under the Transfer of Funds Regulation (TFR), move with it?

Last month, the EBA concluded that such transactions fall within the scope of the TFR.[1] The EBA did not specifically address the technical features of the Lightning Network and concluded that such transactions fall within the scope of the TFR because a CASP that facilitates Lightning transactions falls within the scope of this Regulation. While this provides a practical solution, it leaves the more technical question: can a second layer transaction, such as one conducted via the Lightning Network, be considered a “transfer of crypto-assets” within the meaning of the TFR?

This article addresses that question in three steps. It first outlines the travel rule and the concept of crypto-assets. It then explains the functioning of the Lightning Network. Finally, it assesses whether transactions conducted on this second layer chain should qualify as “transfers of crypto-assets” under the TFR.

The travel rule, crypto-asset transfers and MiCAR

The ‘travel rule’ is established in the TFR and requires that all identifying information on the originator and the beneficiary accompany a transfer, so that obliged service providers can screen, monitor and trace transactions for AML/CFT purposes. This is, amongst other things, the information you see when making a specific payment transaction in your banking application (i.e. name, IBAN, etc.). In the context of crypto-assets, the rule is intended to ensure that crypto-asset transfers do not become opaque merely because they are executed through decentralised or pseudonymous infrastructure.

In accordance with Article 2(1) TFR, the TFR is also applicable in relation to transactions that constitute:

‘the transfer of crypto-assets, including transfers of crypto-assets executed by means of crypto-ATMs, 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’

Following Article 3(10) TFR a ‘transfer of crypto-assets’ means, in short, any transaction at least partially carried out by electronic means on behalf of an originator or a beneficiary through a crypto-asset service provider, with the aim of moving crypto-assets from one distributed ledger address (or other account or device) to another. Thus, if a crypto-asset service provider (CASP) is involved in transferring crypto‑assets, it must, in line with the travel rule, ensure that all required relevant information on the originator and the beneficiary accompanies the transfer of crypto-assets.

In terms of definitions the TFR aligns with the Markets in Crypto‑Assets Regulation (MiCAR). Importantly, Article 3 MiCAR defines a ‘crypto-asset’ as:

‘a digital representation of a value or of a right that is able to be transferred and stored electronically using distributed ledger technology or similar technology’

Distributed ledger technology means – in simple words – a technology through which (automatic) agreement between parties is reached by consensus among multiple devices or processes (such as computers and smart contracts). This process, where validation of the transactions occurs without the intervention of a bank or PSP is more commonly known as the ‘blockchain’.

Thus, a digital representation of value or a right that is transferred and/or stored by blockchain technology or similar technology is qualified as ‘crypto-asset’.

What is the Lightning Network?

The Lightning Network is different from regular blockchain transactions. It is also known as a ‘second layer’ network built on top of the first‑layer blockchain. As the Bitcoin blockchain became overwhelmed by too many transactions and transaction times and fees skyrocketed, there was a need for scaling solutions for small transactions. The Lightning Network was built to address that need.

The Lightning Network is a second layer, off-chain solution built on top of the Bitcoin-chain that enables instant and low-cost (micro)payments through private payment channels between participants. As the transaction on the blockchain is already validated when opening the channel, the Lightning transactions are not validated and can be executed instantly. The Lightning transactions are recorded within these channels, while the actual settlement only occurs when the channel is eventually closed and the below Bitcoin transaction is settled. Only the opening and closing settlement of the channel will be visible on the blockchain, not the individual payment-channel updates within the private Lightning channel.

In simple words: the Lightning Network can be understood as a private channel in which transactions in crypto‑assets (Bitcoin) are recorded off-chain, while final enforceable settlement remains anchored in the underlying Bitcoin blockchain.

• Example A: Anne and Bram open a payment channel on the Lightning Network with 1 BTC that is locked on the first layer blockchain. With this locked amount they can execute multiple micro‑transactions on the Lightning Network. The end balance of Lightning transactions between Anne and Bram is, for example, 0.1 Bitcoin for Anne and 0.9 Bitcoin for Bram. When the Lightning channel is closed by the parties, 0.1 Bitcoin goes to Anne’s wallet and 0.9 Bitcoin goes to Bram’s wallet, as settled on the first layer blockchain.

In addition to the above, it is possible to connect Lightning channels to each other. This means multiple channels can form a cluster, allowing Lightning payments to be routed indirectly between participants. This feature of the Lightning Network is important because it emphasises that it is not merely a private channel but also (unknown) third parties can be part of the transactions. This complicates traceability and imposes AML-related risks, which could be reasons for the regulators to take a hard stance against the Lightning transactions.

• Example B: Anne can have a payment channel with Bram where direct transactions between them are recorded. However, Bram could also have a payment channel with Chris, allowing Anne to make Lightning transactions with Chris through Bram.

Are Lightning Network transactions ‘crypto-asset transfers’?

We have described a general image of the legal and technical structure of the Lightning Network. The subsequent question is now: do transactions on the Lightning Network fall within the scope of the TFR as ‘transfers in crypto-assets’?

EBA’s Position on Lightning Network Transactions

The AFM explained that Lightning transactions between two participants or ‘nodes’ take place off-chain and are not recorded on the blockchain. Only when the private channel is opened or closed through the Bitcoin blockchain is an on‑chain transaction made that reflects the channel’s opening and closing balances. According to the AFM, Lightning transactions are therefore neither transparent nor traceable on the blockchain. The AFM was concerned that if such transactions were to be outside of the scope of the TFR, an undesirable shift of transactions onto Lightning channels may occur.

The EBA’s answer concluded that CASPs offering customers the possibility to transfer crypto-assets through the Lightning Network fall within the scope of both MiCAR and the TFR and must therefore comply with the travel rule obligations. At the same time, the EBA confirms that purely peer-to-peer use of the Lightning Network, outside the involvement of CASPs, falls outside the scope of MiCAR (see Recital 22 MiCAR) and consequently outside the TFR framework.

The EBA’s response appears less focused on whether each individual Lightning transaction itself qualifies as a “transfer of crypto-assets” under the TFR, and more on the broader regulatory perimeter question: if a CASP facilitates Lightning Network activity for customers, then that CASP-facilitated activity falls within the scope of the TFR.

Technical view on qualification

Although pragmatic (also given the AML risks), the answer of the EBA is not very clear on why CASPs must ensure that the travel rule applies to the specific ‘Lightning transactions’. The EBA thereby leaves the more interesting question largely unanswered: do individual Lightning transactions themselves constitute a ‘transfer of the crypto-assets’ within the meaning of the TFR?

First, as mentioned by the AFM and the EBA, Lightning transactions are ‘off-chain’ transactions that are not individually settled on the blockchain. This raises the question whether an individual Lightning transaction involves a ‘crypto‑asset’ as defined in MiCAR. Technically speaking, the ‘value or right’ represented by the Bitcoin is neither transferred nor stored on the Lightning Network but only on the Bitcoin blockchain (first layer).

That said, the MiCAR definition of a crypto-asset is deliberately broad and refers not only to distributed ledger technology, but also to ‘similar technology’. This wording leaves room for an argument that second layer arrangements such as the Lightning Network may be sufficiently connected to, or comparable with, DLT-based infrastructure to fall within the regulatory concept.

Second, the Lightning Network operates through a subsequent private channel between participants which balance updates are recorded off-chain, while final settlement takes place on the first layer (Bitcoin) blockchain. If the relevant off-chain update does not itself settle the underlying Bitcoin on-chain, the question is whether it should be characterised as a ‘transfer’ of crypto-assets or rather as an interim update to payment-channel balances that may ultimately be reflected in an on-chain settlement.

Put simply, consider the example of the well-known Dutch administrative app Wie Betaalt Wat below.

• Example C: Anne buys groceries for her roommates Bram and Chris at the supermarket and registers this transaction in the Wie Betaalt Wat-application. At the end of the month, the balance between the roommates is settled and they will pay each other in accordance with the end-balance.

In the example above, when Anne puts the transaction of groceries on Wie Betaalt Wat-application, does this already constitute a transfer of Anne’s funds? Or does the transfer only occur when the balances are settled at the end of the month? This simple analogy illustrates the distinction between interim balance updates and actual settlement of the underlying assets or funds.

From a technical perspective, it is arguable that Lightning transactions do not constitute a ‘transfer’ of crypto-assets within the meaning of TFR and the travel rule. Transactions on the Lightning Network arguably represent something different: temporary off-chain administrative records that may eventually lead to an on-chain settlement.

[1] EBA, Q&A 2024_7172.