Fedimint

Private Bitcoin banking for everyone?

Background

Fedimint is an intriguing modular open source protocol to custody and transact bitcoin in a community context, built on a strong foundation of privacy. The following discussion is derived primarily from the Fedimint website’s open source documentation, along with my commentary on what I see as some of the most exciting use cases for this technology.

For a brief overview, here’s a great talk about Fedimint from the 2022 Bitcoin conference, from Obi Nwosu. Robert Breedlove also had an extended discussion with him on his podcast the What Is Money Show, which is worth watching.

Why Fedimint

Fedimint is a concept aimed at simplifying the user experience, promoting privacy, and addressing scalability challenges in Bitcoin. It focuses on three pillars: community custody, financial privacy, and scaling.

1. Community Custody Fedimint recognizes that running a personal Bitcoin node and managing funds can be technically challenging for many users. To address this, Fedimint proposes the creation of community-focused banks called "Fedimint Federations." These federations allow users to bank themselves by distributing custodianship across trusted communities. Users can onboard new members into Bitcoin, acting as "2nd party custodians" within their trusted circle of friends and family. This provides a middle ground between third-party custodians and self-custody.

2. Financial Privacy Fedimint incorporates cryptographic techniques like Chaumian eCash notes and blinded signatures to achieve privacy for federation members. Federation guardians cannot correlate transaction inputs and outputs or track individual account balances, transaction identities, or holdings. This privacy enhancement distinguishes Fedimint from third-party custodians, which have access to detailed transaction information.

3. Scaling Fedimint acknowledges the limitations of the current Bitcoin UTXO set in scaling to serve billions of users with personally owned UTXOs. It proposes an alternative solution by federating custody of funds while maintaining interoperability with the Lightning Network. This allows users to aggregate and share ownership of UTXOs through shared cold storage or lightning channels. Fedimint collapses the economic density of a community into a small number of lightning nodes, similar to how a road network connects multiple towns. This model aims to create a more flexible, scalable, and efficient lightning network. For more on UTXO’s check out my recent post:

For more on the Lightning Network check out my post here:

The ultimate vision of Fedimint is to have a world with hundreds of thousands to millions of community banks running on the federated model, inter-operating over the lightning network. This could potentially increase the efficiency of the lightning network while enabling increased demand and earning potential for Lightning Service Providers (LSPs).

Who Are the Federations?

Federations within the Fedimint framework refer to groups of individuals who come together to form a community-focused bank for the purpose of custodying and transacting with Bitcoin. These federations can vary in size, scope, and trust models, depending on the community involved.

The concept of federations encompasses various groupings, such as:

1. Family Federation This type of federation consists of close family members who have a high level of trust but a smaller anonymity set. It is suitable for long-term holding of funds and can be used to refill other federation wallets to facilitate spending.

2. Friends Federation Similar to the family federation, this grouping includes close friends who may act as custodians. It offers a wider anonymity set compared to the family federation and serves as a backup option for individuals without direct family members involved.

3. Community Federation These federations are formed within larger community settings, such as regional areas, and function as infrastructure for facilitating spending. They operate similarly to community banking and involve small-value wallets that are regularly topped up and depleted.

4. Private Online Federation This type of federation explores the design space for temporarily holding funds, particularly for executing smart contracts or delivering complex services.

When joining a Fedimint federation, it's crucial to understand the trade-offs involved and "know your federation." Trusting the federation's guardians is an essential aspect of the Fedimint model. The incentive for guardians not to collude is the close, trusted relationships they have with federation members, who can socially and physically respond should the guardians break the trust model.

Fedimint is designed to be used by pre-existing groups with high levels of trust, such as families, friends, small villages, or community organizations. This trust model, known as second party trust, mitigates custodial risks. These groups often operate within non-commercial contexts and may even formalize their operations with constitutions.

While current Fedimint implementations are non-commercial, the open protocol allows for the formation of commercial federations in the future. Such entities would help decentralize custody and transaction infrastructure to local levels, fostering competition and potentially improving customer experiences.

What is a Fedimint?

A Fedimint, short for "Federated Mint," is an implementation of Chaumian eCash that utilizes a federation of guardians for fund custody instead of a centralized entity. It is designed to be interoperable with Bitcoin's Lightning Network and offers strong privacy for users.

A Fedimint operates as a community-run system, with multiple federated mints deployed globally, catering to both small and large community instances. The user experience of a Fedimint is similar to that of a custodial lightning wallet, providing users with the advantage of privacy from federation guardians and a native backup scheme to recover funds.

The Fedimint system consists of five functional components: accounts, custody & redemption, backup & recovery, transaction processing, and an LN Gateway. These components are supported by three core technology components.

The guardians of a Fedimint are technical community members responsible for running the federated Chaumian eCash system. They custody and backup funds, mint and redeem eCash notes, and coordinate using a distributed consensus protocol. The guardians' role is to ensure the security and integrity of the system, and their actions are governed by a consensus mechanism.

Users of Fedimint interact with the system using Fedimint-compatible wallet software, such as Fedi. Users can create accounts, deposit bitcoin in exchange for eCash notes, redeem eCash for on-chain bitcoin, and manage backup and recovery of their wallet data. They can also engage with the Lightning Network through a Lightning Gateway, which may be operated by a Fedimint user or the federation itself.

The Lightning Gateway provider is a Fedimint user who also runs a Lightning Network node. They facilitate Lightning Network transactions for users within the federation, allowing them to pay Lightning invoices or receive lightning payments. The Lightning Gateway interacts with the broader Lightning Network outside of the Fedimint system.

Overall, Fedimint empowers communities of Bitcoiners to collaborate, assist each other with custody and backup arrangements, and make lightning payments while maintaining privacy and control over their funds.

Core Technology Components

The core technology components of Fedimint are Chaumian eCash, federations, and lightning swaps.

Chaumian eCash is a technology that allows Fedimint to create and redeem IOU notes representing claims on bitcoin. It was developed by David Chaum in 1983 and enables anonymous transactions through the use of blind signatures. Users can transact privately without revealing specific transaction details or balances, which is important for maintaining privacy in a community banking setting.

Federations play a crucial role in Fedimint. The mint is jointly owned and operated by multiple guardians. This approach offers several advantages over a single-server deployment. It reduces the risk of a single individual having control over the funds, increases redundancy in case guardians go offline, and changes the regulatory landscape as no single person controls coin issuance and redemption. This federated model aligns with the best practices of multi-signature custody used by exchanges and custody providers.

Integration with the Lightning Network is achieved through lightning swaps. A lightning gateway operator acts as an intermediary between Fedimint bitcoin and Lightning Network bitcoin. They facilitate the exchange of assets by accepting Fedimint bitcoin to pay Lightning invoices on behalf of users or by accepting incoming Lightning invoices and paying users in Fedimint bitcoin. These transactions are secured using a common Hash Time Lock Contract, extending the Lightning route into the federation. Multiple lightning gateways can be operated within a Fedimint, allowing users to become lightning gateways as long as they run a Lightning Network node.

By combining Chaumian eCash, federations, and lightning swaps, Fedimint provides users with delegated management of their bitcoin holdings and Lightning nodes while preserving financial privacy.

How Do Fedimint Transactions Work?

Fedimint transactions can be categorized into several scenarios: transactions within a Fedimint, transactions from Fedimint to the Lightning Network, transactions from Fedimint to other Fedimints, and payments from a Lightning wallet into a Fedimint wallet.

For transactions within a Fedimint, the process involves an invoice being passed from one user's wallet to another, followed by the selection and sharing of eCash notes to fulfill the payment. To settle the transaction, the recipient submits the eCash notes to the Fedimint for redemption and requests fresh eCash notes in return.

When sending a payment from a Fedimint to the Lightning Network, a Hash Time Lock Contract (HTLC) is used. The recipient generates a lightning invoice that acts as an HTLC contract. The sender, who may not have a lightning wallet, creates an equivalent HTLC contract within the Fedimint, offering a reward (fm-sats) for anyone who can supply the pre-image linked to the recipient's contract. A Lightning Gateway provider is incentivized to pay the invoice, routing a payment through the lightning network to the recipient and obtaining the pre-image. The Gateway can then claim the reward in fm-sats from the sender's contract.

For transactions between different Fedimints, the payment is routed over the lightning network. The sender sells a pre-image for fm-sats, and the recipient is provided with a Lightning invoice that includes information about the Fedimint and a route hint to a Lightning Gateway. The sender and recipient both post contracts to their respective Fedimints, and the Lightning Gateways facilitate the payment and settlement process.

When making a payment from a Lightning wallet into a Fedimint wallet, the process is similar to the transaction between different Fedimints. The sender skips the step of buying a pre-image and directly pays the Lightning Gateway.

Trust Model Tradeoffs

The Fedimint protocol introduces trade-offs in order to provide benefits such as financial privacy, community custody, and transnational scaling. These trade-offs are based on trust assumptions within the system. The trust assumptions in Fedimint are as follows:

1. Custody Users must trust the Federation Guardians with the custody of their funds, which introduces custodial risk.

2. LN Pay Users must trust "1 of n" Lightning Gateways to pay Lightning invoices outside of the mint.

3. LN Receive Users must trust "1 of n" Lightning Gateways to receive Lightning payments into the mint.

4. Tx Execution Users must trust a quorum of Federation Guardians to process transactions, including deposit, redeem, swap, and contract enforcement.

On the positive side, users benefit from attributes such as blind balance (guardians cannot see a user's balance), blind transactions (guardians cannot identify transaction parties), unattended LN deposits (users can receive Lightning payments without being online), and simplified use (operation of Bitcoin and Lightning nodes is outsourced to the federation of LN gateways).

Fedimint is a voluntary system, and individuals can choose to use it partially or fully for their Bitcoin custody. Understanding the trade-offs helps individuals make informed decisions based on their risk profiles.

The trade-offs in the trust model give rise to five key risks, which are outlined as follows:

1. Custodial Risk The risk of the federation stealing or losing funds.

2. Debasement Risk The risk of the federation issuing more claims to Bitcoin than they actually own.

3. Regulatory Risk The risk of the federation being unilaterally shut down or forced to cease operations due to regulatory actions.

4. LN Gateway Censorship Risk The risk of Lightning Gateways refusing service to mint users.

5. Transaction Censorship Risk The risk of the federation refusing service in certain instances.

Summary:

Fedimint serves as a custody model for individuals who prefer not to self-custody their Bitcoin. It recognizes that as Bitcoin adoption grows, not everyone will have the technical know-how or desire to self-custody their funds. Fedimint offers a private and censorship-resistant way to deposit and withdraw Bitcoin, acting as a bank-like system with trusted Guardians who use multisignature and a quorum to move funds securely. Unlike traditional banks, Fedimint does not involve loaning money, paying interest, or charging fees. Instead, funds are 100% backed by Bitcoin deposits, resulting in minimal government regulation in most jurisdictions.

The recent failure of Custodia Bank's attempt to establish a 100% reserve bank in the US highlights the potential for Fedimint's adoption outside the US, particularly in the Global South, where there is a growing interest in Bitcoin as a monetary solution. While this introduces regulatory risks, one compelling use case is the application of Fedimint in credit unions or community banks. Depositors can store their Bitcoin in the Fedimint "bank," and Guardians can make loans for community projects using appropriate underwriting standards and market-based terms and interest rates. The earnings from lending activities could benefit members by reducing loan rates or be paid as interest to Bitcoin depositors, similar to how credit unions operate today.

Fedimint provides minimal tools for operations, monitoring, and management, allowing for maximum flexibility. Furthermore, the protocol offers APIs that enable third-party applications and services to extend functionality and cater to specific user needs. This promotes innovation and competition within the ecosystem, opening up possibilities for diverse services and solutions beyond the core protocol. Fedimint's potential applications could extend to custody models such as insurance, trusts and estates, and real estate, although these would require more complex setups and likely face increased government regulation.

Not financial or legal advice, for entertainment only, do your own homework.  I hope you find this post useful as you chart your personal financial course and Build a Bitcoin Fortress in 2023.  To see all my books on investing and leadership, click here.  

Always remember: freedom, health and positivity!  

Please also check out my Building a Financial Fortress Podcast on YouTube here and on all your favorite streaming platforms. I do a weekly Bitcoin news update every week on current items of interest to the Bitcoin community, usually 30 to 60 minutes depending on the number of topics to cover. Please check it out if you haven’t already. Also now on Fountain, where you can earn Bitcoin just for listening to your favorite podcasts.