The Bitcoin/blockchain Lightning Network is a decentralized network that allows participants to send transactions at high volume and high speed.
The Bitcoin Lightning Network is a second layer to the cryptocurrency’s blockchain that supports off-chain transactions, which are those between parties that aren’t on the Bitcoin blockchain network. The second layer consists of multiple payment channels that exist between users of Bitcoin or other parties.
Characteristics of the Bitcoin Lightning Network
Each Lightning Network channel is a transaction method involving two parties in which the parties can exchange payments between each other. The second layer of the blockchain manages transactions that occur outside the blockchain’s mainnet, which is the first layer, thus enhancing the blockchain applications’ scalability.
The transactions that occur on the second layer of the blockchain still benefit from the decentralized security of the mainnet even though they are occurring off the blockchain. Lightning Network transactions also enjoy the other benefits of the Bitcoin blockchain, including the fact that it is decentralized, permissionless, and open source. The security of the Bitcoin Lightning Network comes from on-chain Bitcoin transactions, which utilize smart contracts to enable off-chain transactions that occur instantly.
According to Cointelegraph, scalability is a major barrier that restrains the adoption of cryptocurrencies. A blockchain network that is scaled correctly can manage millions or even billions of transactions every second.
To settle and transact off the blockchain, the Lightning Network charges ultra-low fees. In fact, the fees are so low that they are almost nothing. In turn, this creates new use cases such as instant micropayments, which allow users to do things like buy coffee using Bitcoin. Micropayments are uneconomical on the mainnet because of base layer fees.
Problems for the Bitcoin blockchain
Bitcoin transactions typically take a significant amount of time and come with sizable energy costs. Additionally, transactions on the Bitcoin blockchain face sizable barriers in the way of fees, transactions per second and network congestion.
Kraken explains that block space is limited, which means mining fees can swing wildly back and forth according to demand for transactions to be included. It takes an average of 10 minutes to process a single block on the Bitcoin blockchain. As a result, Bitcoin can only complete about seven transactions per second, and slow block times and increased network use can cause delays in confirmations of transactions.
However, off-chain transactions conducted on the Lightning Network speed up the processing times and cut the energy costs associated with using Bitcoin. The Bitcoin Lightning Network breaks through these barriers by providing instant, cheap transactions with about 1 million or more transactions per second.
As of August, statistics from the Lightning Network indicate that over 2,000 Bitcoins have been transferred over the network.
Background of the Bitcoin Lightning Network
Joseph Poon and Thaddeus Dryja developed the idea of the Lightning Network, publishing their concept initially in a whitepaper in 2015. They based their writings on earlier discussions about payment channels between the anonymous creator of Bitcoin, widely referred to as Satoshi Nakamoto, and fellow developer Mike Hearn. Hearn published their discussions about payment channels in 2013.
The abstract of Poon and Dryja’s paper describes what we now know as the Lightning Network as an off-chain protocol consisting of payment channels. Within each of those channels, two untrusted parties can exchange payments without causing congestion in the mainnet. The off-chain channels are aimed at solving the problem of scalability with Bitcoin.
Dryja and Poon explained that Visa processed 47,000 transactions per second at its peak during the holiday shopping season in 2013. They added that for Bitcoin to approach that level, it would have to handle eight gigabytes’ worth of transactions for every block, which is far from the Bitcoin blockchain’s capabilities. The Lightning Network allows Bitcoin to scale through the creation of payment channels that process transactions off the mainnet without congesting it.
Poon and Dryja joined with other contributors in 2016 to found Lightning Labs for the purpose of developing the Lightning Network. The company worked on making the protocol compatible with Bitcoin’s core network. In 2017, a major breakthrough followed Bitcoin’s SegWit-based soft fork, which cleared some space to allow for more transactions in every block. It also eliminated a persistent bug referred to as transaction malleability, which enabled users to hold on to their Bitcoin by faking transactions.
Pre-launch testing enabled developers to build apps on the Lightning Network immediately, utilizing simple use cases like wallets and gambling platforms. Lightning Labs finally launched the beta of its Lightning Network in 2018, with well-known names like Twitter founder Jack Dorsey getting involved.
How the Lightning Network works
The Lightning Network protocol allows peer-to-peer payment channels between two parties to be created. When a channel is established, it enables the parties to exchange an unlimited number of instant transactions inexpensively. The payment channel acts as its own ledger without impacting the Bitcoin network.
The payer creates a payment channel by locking in a certain amount of Bitcoin into it. The recipient can then invoice for certain amounts of the cryptocurrency, and if the customer wants to keep the channel open, they can keep adding more Bitcoin.
When the two parties have no more transactions to make, they can close the channel. At that point, all of the payments exchanged within the channel are consolidated into one transaction, which is then sent to the mainnet for recording in the Bitcoin blockchain.
Pros and cons of the Bitcoin Lightning Network
The biggest advantages of the Lightning Network are the ultra-fast transaction speeds and the low fees. Additionally, transactions carried out on the Lightning Network still benefit from Bitcoin’s security protocols. The Lightning Network also allows for private transactions. Further, cryptocurrency enthusiasts have been trying out the concept of atomic swaps, which involve trading one type of cryptocurrency for another without a third party or a crypto exchange.
However, there are also some disadvantages to the Bitcoin Lightning Network. For example, there is a fee associated with transferring Bitcoin from a traditional Bitcoin wallet to a wallet compatible with the Lightning Network.
Additionally, when the payer creates a payment channel with another user, the Bitcoin they deposit is locked in the channel. Neither party can pull out some of the funds in the payment channel. In order to receive their funds, they have to close the channel and take out all the Bitcoin. Further, when opening or closing a payment channel, both parties must pay a routing fee, which increases the cost of transacting on the Lightning Network.
Scams are one of the most significant problems with the Bitcoin Lightning Network. If one of the parties in a payment channel closes it while the other party is offline, they can steal the Bitcoin that’s in the channel. Then when the other party comes back online, they can’t get their Bitcoin back. The scammer can simply stay offline, providing no way for the other party to contact them.
As with all technology, glitches are also a problem with the Lightning Network. Sometimes payments get stuck, meaning that they aren’t verified right away. The network will refund a stuck payment, but that can take days.
Finally, regulation could pose a problem for the Lightning Network in the future. Despite the appointment of crypto-friendly regulators like Gary Gensler, most regulators probably don’t understand the Lightning Network, making it impossible for them to enact the proper legislation. Even if the regulators do understand the protocol, they might not allow the Lightning Network to continue due to its anonymity.
Growth in the Bitcoin Lightning Network
Since the beta was launched in 2018, the Lightning Network has grown significantly. According to CoinDesk, the number of public nodes grew from 6,040 in July 2020 to 12,675 in July 2021. This number would be much higher if private connections, which are only accessible to approved users, were included.
Although the Lightning Network has grown dramatically in recent years, it still isn’t ready to solve Bitcoin’s scalability problem. Security is the biggest problem because all the nodes on the Lightning Network must be online at all times, making them vulnerable to cyberattacks. Additionally, although the network aims to reduce fees for transactions, there still are some hidden fees that users need to be aware of, such as the routing fees to open or close a payment channel.
However, the Lightning Network is proving to be an important part of the Bitcoin blockchain in multiple ways. Cryptocurrency exchanges have begun to adopt the Lightning Network protocol to optimize Bitcoin withdrawals and deposits for their users.
Kraken decided to add support for the Lightning Network this year, as did CoinCorner in the U.K., OKCoin in the U.S., and VBTC in Vietnam. This adoption among crypto exchanges signals that the Lightning Network has a bright future ahead of it.
- Bitcoin’s Lightning Network is a decentralized network that allows participants to send transactions at high volume and high speed.
- The Lightning Network protocol allows peer-to-peer payment channels between two parties to be created.
- When a channel is established, it enables the parties to exchange an unlimited number of instant transactions inexpensively.
- The payment channel acts as its own ledger without impacting the Bitcoin network.
- Since the beta was launched in 2018, the Lightning Network has grown significantly.
Pierre Raymond is a 25-year veteran of the Financial Services industry. Driven by his passion for financial technology he has transitioned from being a quantitative stock picker to an award-winning hedge fund manager, credit risk manager to currently a RISK IT Business Consultant. Pierre is the cofounder of Global Equity Analytics & Research Services LLC (GEARS) and a current partner at OTOS Inc.