Bitcoin Lightning Network Explained

Konrad Rotkiewicz
31 March 2020 · 5 min read

The first person to comment on Satoshi Nakamoto’s Bitcoin white paper in November of 2008 was the anonymous Canadian cypherpunk “James A. Donald.” In his critique, Donald said that Bitcoin “does not seem to scale to the required size” and would go on to debate Satoshi on whether Bitcoin has the capacity to scale enough to be a mainstream payment method. Over ten years later Donald proved to be correct and scalability turned out to be one of Bitcoin’s biggest challenges. Bitcoin will have to process millions of transactions each day in order to function as a currency for widespread daily use. One potential solution to Bitcoin’s scalability issues is Lightning Network. It's an off-chain approach to crypto transactions that allows small, everyday transactions to be stored off the main Bitcoin blockchain.

What is Lightning Network?

Looking to solve Bitcoin’s scalability issues, Joseph Poon and Thaddeus Dryja outlined Lightning Network in a 2016 whitepaper. In this paper, they illustrate how difficult it would be to scale bitcoin and how it would require “over 400 terabytes of data per year” to be stored in the blockchain for Bitcoin to process the same number of transactions as Visa does. Visa, for example, processes an average of 1,700 transactions per second, while the Bitcoin network can only handle around 4.6 transactions per second.

Lightning Network is under development and proposed as a second-layer technology to augment Bitcoin. It uses micropayment channels in order to scale Bitcoin’s capacity to process transactions. The fundamental idea is that taking transactions off the Bitcoin blockchain will decongest the system and reduce transaction fees. Lightning Network also facilitates off-chain transactions of different cryptocurrencies.

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How does Bitcoin lightning network work?

On the technology side, it utilizes smart contracts created on top of base Bitcoin blockchain. To facilitate fast and cheap direct payments a multi-signature wallet is created to hold a certain amount of bitcoin. This can be provided by one or both of the parties of the transaction. The addresses of those wallets are then saved to public bitcoin blockchain including the smart contracts proving owners of bitcoin deposits in them.

How it works is an initial transaction, known as the Funding Transaction, which is created by one or both parties when they fund a channel. This is one or two of a maximum of three transactions that are actually broadcast to the blockchain network during the lifespan of a funding channel. Following this initial transaction, any number of lightning transactions can happen between the two parties. Each is signed by both and only kept by them. The payment channel can be closed at any time by either of the parties by submitting the final version of the settlement transaction to the bitcoin network (since they each have a signed copy). When that happens only the result of all of the lighting transactions is stored on the bitcoin blockchain, greatly reducing the number of transactions stored.

What are the benefits of Lightning Network?

Although still under development, Lightning Network is planned to launch in 2020. Blockchain companies are watching the release closely. If it is successfully implemented, it will add a number of features and advancements to Bitcoin. One benefit is increased transaction speed. Once the network is up and running transactions will be nearly instantaneous regardless of how busy the network is. In addition, users will not have to endure several confirmations for every transaction being made.

A huge benefit of Lightning Network will be the ability to send micropayments as the fees are proportional to the payment amount. Accounting can be even done in thousandths of a satoshi.

Another benefit of Lightning Network is the ability to execute cross-chain atomic swaps. Lightning Network users can send funds between different cryptocurrencies as long as they share the same cryptographic hash function and have compatible second layer protocol. Also, it must be possible to execute trustless transactions between given blockchains for this to be possible. This technology allows users to send funds from one chain to another without requiring the trust of a third-party (like an exchange).

Lightning Network will vastly improve Bitcoin’s scalability. It will allow the processing of millions to billions of transactions per second across the network. Compare this to Bitcoin’s current limit of around 7. Lightning Network has the potential to be revolutionary to Bitcoin because of this.

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Lastly, Lightning Network improves upon the privacy of Bitcoin payments. Unlike usual Bitcoin payments, where each transaction is permanently stored on the public blockchain, Lightning Network’s transactions happen off-chain and are not publicly recorded on the blockchain directly. Those payments may be routed through many sequential funding channels across the lightning network where each node operator will be able to see payments across their channels, but they will not be able to see the source nor destination of those funds. This makes payments nearly impossible to trace.

What are the drawbacks of Lightning Network?

Despite all the above benefits, there are drawbacks to factor in. One flaw in the design is that it does not support offline payments. You must have an internet connection. This means any funds you hold in Lightning Network are also held online and potentially susceptible to hacks. It also means you can't make use of cryptocurrencies you have in cold storage.

Lightning Network does not work well for large payments. It wasn’t designed for that use case, and it’s intended use is small to medium-sized transactions. Using it for large transactions ties up the funds in a channel until the channel is closed. This means Lightning Network users may have to decide between having liquidity in Bitcoin or on Lightning Network. In addition when two users establish a channel the initial amount of funds locked by the funding transaction is the maximum that can be transferred across this channel. This means that even though a route via various payment channels might exist the funds in corresponding wallets might be insufficient to transfer large funds.

There is a theory that once Lightning Network is launched it might incentivize centralization, similar to what is seen with miners centralization. There is a concern that payment ‘hubs’ will be created - nodes with a ton of capital - through which the majority of transactions will pass, thus centralizing the network. A failure at one hub could potentially crash a large portion of the Lightning Network.

Conclusion

Four years after it was originally conceived, Lightning Network is set to launch in 2020 and could potentially revolutionize Bitcoin. It is a second-layer technology that uses micropayment channels to scale Bitcoin’s ability to process transactions. Hopefully, this will pull smaller transactions off of Bitcoin’s main blockchain and decongest the system.

Lightning Network is set to increase transaction speeds, decrease transaction fees, allow for cross-chain atomic swaps without the need for a third party and improve the privacy of transactions by taking them off-chain. However, this innovation does not support offline transactions, ties up funds in open channels and may have encouraged centralization.

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