Bitcoin
June 1, 2022

Bitcoin Lightning Network Explained

The Lightning Network is one of the most important innovations to help Bitcoin scale as a global medium of exchange. This article covers what Lightning is, why it's so important, and how it works.
4 min

Summary

The Lightning Network is a scalability solution built on top of the Bitcoin network that allows users to quickly send and receive Bitcoin with virtually no fees. It was developed to help overcome some of Bitcoin’s inherent scalability challenges and to further the adoption of day-to-day Bitcoin payments. It is reliant on smart contracts to establish off-chain payment channels between pairs of users. The Lightning Network is one of the most promising innovations in the Bitcoin space and is set to shock the system of traditional payment networks.

What is the Lightning Network?

The Bitcoin Lightning Network (also referred to as Lightning, or LN) is a secondary layer on the main Layer 1 Bitcoin blockchain. This Layer 2 solution is separate to the bitcoin network - it does not have a token or blockchain. Instead, Lightning utilises Bitcoin for payments and its blockchain for final settlement and security. Lightning is made up of a system of payment channels that move transactions off the base bitcoin blockchain (off-chain). This allows parties to move bitcoin between one another without needing to use the blockchain to verify transactions.

Similar to the Bitcoin Network, Lightning is made up of a network of nodes (computers) running the Lightning software, that process payments. Individual Lightning nodes transact with one another privately through payment channels between pairs of users. Transactions are commonly made using QR codes instead of complex public keys.

Why is the Lightning Network Important?

As the world’s first and leading cryptocurrency, Bitcoin has become a critical means of storing and transacting value globally. Bitcoin’s unique properties have helped it establish a strong narrative as a digital store of value or ‘digital gold’ - an inflation resistant way to store wealth over time. However, the Bitcoin network has experienced considerable scalability challenges as it has grown over the years. Currently, Bitcoin faces the following limitations:

Transaction fees: Block space is a scarce resource (only 1 MB). Bitcoin blocks are created approximately every 10 minutes, and can only hold so many transactions. Transaction fees can fluctuate wildly based on network demand. For example, at the height of the 2017 bull market, fees exceeded $50.

Transactions per second: Bitcoin is only capable of approximately 7 transactions per second (TPS).

Network congestion: Slow block times and heightened use of the network can result in delays in transaction confirmations.

The Bitcoin Lightning Network was developed, in part, to further the adoption of day-to-day Bitcoin payments, and enable it to function more like the peer-to-peer digital cash envisioned by Satoshi Nakamoto in their seminal white paper. There are several benefits to using the Lightning Network, with some of the main ones discussed below.

What are the Benefits of the Lightning Network?

Instant Payments: True to the name, this Layer 2 solution promises lightning-fast payment transactions. There are no block confirmations to wait for – payments can be made as fast as your internet connection will permit.

Scalability: Where the Bitcoin blockchain can typically handle 7 TPS, Lightning can theoretically handle millions of transactions a second. This capacity blows away legacy payment rails by orders of magnitude - with the Visa network typically handling around 1,700 TPS on average.

Low cost: By transacting and settling off-chain, Lightning allows for exceptionally low fees - typically fractions of a cent. Lightning transactions are also less energy intensive than transactions on the main blockchain as miners are not needed to verify every transaction.

Privacy: Lightning offers users a high degree of confidentiality. Parties do not need to make their channels known to the broader network. Only the opening and closing of channels is recorded on-chain, so onlookers cannot look at every individual transaction within the channel.

How does the Lightning Network Work?

Lightning Payment Channel

A Lightning channel is a bidirectional payment channel, meaning both parties can send and receive payments across the channel. To create a payment channel, parties must deposit or lock some Bitcoin into the channel. Once open, a Lightning channel enables both parties to execute any number of transactions cheaply and instantly. The channel acts as its own mini-ledger, where users can transact between them without broadcasting every transaction to the base layer of the Bitcoin blockchain.

Either party can decide to finish transacting or close the payment channel at any point in time. Funds are sent to each party according to the channel’s transfer history (or mini-ledger of transactions). All of the transaction information is then consolidated into a single transaction, which is sent to the Bitcoin blockchain. The only Lightning-related transactions that are broadcast to the Bitcoin network are the opening and closing of channels.

For example: Let’s say you go to your local coffee shop every day and want to pay in Bitcoin. With Lightning, you could open up a payment channel with the coffee shop with funds locked into the channel. Each coffee purchase would be recorded within that channel, and the transaction would be instant and almost free. When the Bitcoin that started the channel is spent, you can choose to close the channel or refill it. If you choose to close it, all transactions within the payment channel will then be recorded on the main Bitcoin blockchain.

Source: https://bitpay.com/

Lightning Network Routing

Cleverly, the Lightning Network doesn’t need to create pairs between all users. Channels can be connected across the network, similar to routing packets on the internet. Routing allows transactions between unconnected parties to occur by transferring funds through interconnected pathways. This can work across multiple ‘hops’, meaning you can effectively pay anyone to whom a path exists. The nodes on Lightning naturally search for the best route to perform the transaction.

For example: If your friend (who you have a channel with) takes you to their favourite coffee shop, which they have a channel with, Lightning would allow you to route your payment through your friend when you pay for coffee without needing to open a channel with the coffee shop. Funds can still be freely transferred between all networked parties.

Current State of the Lightning Network

Since its launch in 2018, Lightning has seen impressive growth. As of May 2022, Lightning boasts upwards of 17,535 online nodes, 85,000 active channels and just over 3900 BTC in capacity. An amazing global visualisation of the Lightning Network and its node connections can be seen below.

Source: https://explorer.acinq.co/

Lightning continues to experience increased adoption globally. As more individuals, entrepreneurs and businesses experiment with and apply this novel technology a growing number of use cases have emerged including:

Cross-border remittance payments: After becoming the first nation to make Bitcoin legal tender, the El Salvador government created Chivo, a Lightning compatible wallet designed to enable seamless cross border payments. Since its launch, Chivo has been used by over 4 million people. Other notable Lightning wallet applications include Walletofsatoshi, Strike, and Moon.

Micropayment streaming: Unlike the base layer Bitcoin Network, Lightning has no minimum transaction value. As a result, Lightning opens the frontier of micropayments. New digital business models have become possible for the first time, where websites or content creators can charge per article or per view of their site.

Social media tipping: Platforms like Twitter and Substack allow users to send and receive bitcoin ‘tips’ via the Lightning Network.

Future of the Lightning Network

The Lightning Network is a crucial innovation in Bitcoin’s path to becoming a mainstream asset, and, ultimately, a widely accepted medium of exchange. As more people join the Lightning Network, the use cases for holding Bitcoin should rapidly expand. Though there are still some usability obstacles to overcome, as it currently requires some degree of technical proficiency to operate a Lightning node and wallet. With the amount of innovation taking place, it shouldn’t be long before we see considerable improvements to the user experience that will strike down the barriers to entry. Lightning’s continued development could foster new business models and provide billions of disenfranchised people with a fast, cheap, and reliable payment system.

Recommended reading: What is a Layer 2?


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