Bitcoin is the most popular cryptocurrency, but its blockchain is infamously slow. The second layer, called the Lightning Network, boosts its capabilities and mitigates transaction costs. This ecosystem for small transactions lets users receive Bitcoin and transfer funds in split seconds. Here is how it works.
Inherent drawbacks of Bitcoin blockchain
At the dawn of crypto, scalability was not on the agenda. Bitcoin's decentralized payment system was revolutionary — it let users remain anonymous while making transactions anywhere in the world.
The number of these transactions grew exponentially — by 2017, millions of consumers had jumped on the BTC bandwagon. The following woes became obstacles to widespread adoption:
- Long processing times. Rising traffic slowed the blockchain down, so sending Bitcoin could take up to 1.5 hours. The mining difficulty also soared, and the blockchain desperately needed a new, lighter way to confirm transactions.
- High costs. High traffic inevitably amplified the costs. At the all-time high in December 2017, users paid $37 on average to process one transaction, regardless of the amount. The fees seemed particularly exorbitant to those who sent fractions of Bitcoin.
- High energy consumption. The Proof-of-Work consensus protocol is extremely unsustainable. With more computations for miners, the energy demands rose. The network needs more power than the entire Czech Republic, while the annual carbon footprint is comparable to that of Romania!
- Absence of smart contracts and multi-signature scripts. The original version of the blockchain had no smart contract support, which allowed Ethereum to forge ahead. Bitcoin also lacked multi-sig, a safeguard that ensures that transfers reach the recipients.
A few years ago, cryptocurrency layers emerged as a solution to these challenges. Now, the primary Bitcoin blockchain serves as the first base layer, with others built separately on top to complement and enhance it.
What is Lightning Network?
The second layer skirts the main blockchain but interacts with it, scaling its capability through micropayment channels. The average payment size is 0.00508484 BTC, and the smallest transactions are worth one satoshi. Here are the basics of this ecosystem:
- The payment channels are ad hoc peer-to-peer connections.
- Each direct channel enables an unlimited number of payments between two BTC users.
- Parties send and receive Bitcoin without engaging Bitcoin's blockchain for verification.
- The ecosystem relies on thousands of nodes for decentralized payment routing. These nodes are operated by individuals or entities — such as corporations — that run dedicated software on PCs, laptops, or even credit-card-sized computers called Raspberry Pis.
- These bidirectional payment channels can perform off-chain transactions involving exchanges between cryptocurrencies (learn about atomic swaps below).
This model raises the capacity to hundreds of thousands, even millions, of instant Bitcoin payments. Overall, compared to the first layer, the Lightning Network makes transactions
- more affordable
- more readily confirmed
What does Lightning Network look like?
The 1ML engine features a visualization of the interconnections between all nodes. You can see that even the most remote ones can connect to others.
How does Lightning Network work?
Thanks to the Lightning Network, participants do not have to wait until the primary blockchain confirms their exchanges. Parties exchange funds within a payment channel as needed. Upon channel closing, their transactions are relayed to the mainnet.
A channel is activated by locking up any amount of BTC. You can then spend it across this unstructured decentralized network as long as necessary until the channel is closed. To receive BTC, a seller creates an invoice, typically in the form of a QR code. Their counterpart needs to scan the code with their Lightning-compatible wallet and confirm the transaction.
This is how Lightning payments go through. As the network name suggests, this usually takes a few seconds. After exiting the channel, the parties can continue using BTC for larger transactions on the main blockchain.
The Lightning model resembles the way Visa and MasterCard work. When a customer pays by card (for example, in a local coffee shop), the settlement is not immediate. All that's needed for a transaction go through a verification of funds from the buyer and a request from the seller. The actual settlement, however, may take days.
How many transactions can Lightning Network handle?
Scalability issues cap the base layer's capacity at 7 TPS (transactions per second) on average. The second layer can support an astounding 1,000,000 TPS per channel, according to Investopedia. What's more, you can send satoshi at the average and median cost (as estimated by 1ML) of less than $0.01.
How Bitcoin Lightning Network extends to altcoins
Atomic swaps are an impressive, albeit less publicized, aspect of the Lightning Network. This protocol relies on smart contracts (hash time-locked contracts) for peer-to-peer crypto exchanges. Direct transfers between blockchains meet the majority of trading needs. This technology could potentially reduce centralization — the influence of major exchanges — in the marketplace.
Cross-chain connections require the implementation of the Lightning Network on the other blockchain, and the assets must use the same cryptographic hash function (for example, SHA-256). Such swaps are not suitable for the public yet — users need to download the blockchains of both currencies — but developers are working on making them more accessible.
Who invented the secondary Bitcoin network?
The origins can be traced back to the works of Bitcoin's pseudonymous creator Satoshi Nakamoto. The concept was formalized in 2016 in the Lightning Network white paper by Joseph Poon and Thaddeus Dryja. They proposed a micropayment channel network as an alternative to altering the main network.
A massive collective effort brought the beta version to life in March 2018. The funding ($2.5 million) came from a seed round that involved Jack Dorsey, a high-profile investor and CEO of Square. One of the contributors to the effort, the Lightning Labs engineering firm, is now responsible for developing the Lightning Network.
Lately, the payment volume has been rising quickly, indicating user transition. Estimates by Arcane Research point to a fivefold (410% year-over-year) increase for Q1 2022. Over the past 12 months, the public capacity of channels has gone up 750%.
In 2019, the Twitter community ran a social media experiment called the Lightning Torch to raise awareness and test the Lightning Network's capabilities. Hodlonaut promised to send 100,000 satoshis to a trustworthy user who would then add another 10,000 satoshis and relay the whole amount to another participant, just like the Olympic torch — hence the name.
The #LNTrustChain hashtag quickly took off. When the torch finally completed its journey, the participants had sent 4.29 million satoshis. This amount was donated to Bitcoin Venezuela, a non-profit organization helping those affected by hyperinflation. Subsequently, the torch was reignited in 2020 and 2021.
Where Lightning Network falls short
Despite the hype, this technological solution has its own costs, and it is not immune to malicious attacks. The volatility of Bitcoin is another issue — if it fails to become a popular payment method, the use of the second layer will be limited. Here are the five biggest obstacles to wider adoption.
Users still pay fees
Some proponents of the Lightning Network misconstrue Bitcoin's transaction cost. The latter does not stem from clogging alone — users still pay for specific activities. The fees do not vanish once transactions are taken off the main Bitcoin blockchain. Aside from the usual Bitcoin transaction fees, participants pay
- Fees for opening and closing payment channels. The Lightning Network still requires an opening transaction, or deposit, made on-chain. Once the bill for a transaction is settled, the parties must record a closing transaction for the amount on the blockchain. This includes the fee for forwarding — either a fixed base fee or a percentage of the transaction amount.
- Fees for routing transactions. Participants pay to have their payments transferred between channels.
- Fees from watchtowers. The watchtowers are third parties that run on nodes to prevent fraud within the network. Many of them charge fees for this service.
Generally, the routing fees are low, but they have a downside. The smaller the amount, the lower the incentive for the nodes that facilitate Lightning payments. In the future, as the network becomes a payment and settlement layer for many businesses, they may begin charging their own fees.
Lack of decentralization
In theory, the Lightning Network can evolve into a hub-and-spoke model — a network connecting every location through a single intermediary. This approach is part and parcel of conventional financial systems, where banks and financial institutions act as hubs for all transactions. Acquiring the majority of open connections could turn the companies investing in nodes into centralized nodes.
Closed Lightning Network channel fraud
In theory, if one of the two parties closes the channel and goes offline, their counterpart could steal some of their money in the channel. Here is how.
Suppose Jack and Jill are transacting — Jill is selling a product worth 1 BTC, but Jack has malicious intent. To open a channel, both parties make a deposit of .5 BTC. After the transaction takes place and Jill transfers the product, she logs off and thereby closes the channel.
If Jack stays online (keeps the channel open), he can broadcast the state before the 1 BTC was sent — a commitment transaction that does not represent the newest channel state agreed upon by the participants as defined in the ION Lightning Network Wiki. When no transaction is done, the blockchain returns the initial deposits to the parties. As a result, Jack would get the product for free.
As Jill has gone offline, she cannot detect this invalid unilateral close, but a Watchtower service could detect it. Jill may use the evidence of the revoked commitment (commitment revocation secret key) to broadcast a penalty transaction that will punish Jack.
The use of wallets, payment channels, and APIs could make The Lightning Network a target for thieves and hackers. Furthermore, parties sign in with their private keys, so their funds could be at risk if their computers get compromised. Finally, if a malicious party congested a channel, the victims would fail to withdraw their funds from the system fast enough.
One of the ways to achieve this is through denial-of-service. This type of attack exhausts the network's resources, so legitimate users cannot access it. If cyber criminals created numerous channels and forced them to expire simultaneously, the block capacity could become overwhelmed.
The Lightning Network is supposed to support the wider adoption of Bitcoin, but the coin is yet to gain mainstream traction. While it is legal in over 100 states, just two countries — El Salvador and the Central African Republic — have made Bitcoin legal tender.
With wider popularity come bigger transaction volumes, more traders, and higher volatility. It is not just supply and demand that sway BTC — according to Nathan Reiff, it also depends on "investor and user sentiments, government regulations, and media hype."
Suppose company A has an invoice from company B in BTC, and it intends to pay after converting fiat money or another cryptocurrency received from customers. As a rule, clients have a specific period, such as 30 days, for payment. If BTC gains 10% by the time the client pays, its volatility will add 10% to the amount.
The same logic holds true for consumer transactions — most individuals get their salaries or wages in fiat currencies. Whenever conversion is mandatory, the exchange risk is real.
Using Lightning Network transactions
There are two ways to connect to the Lightning Network — Bitcoin users can run a node or use a Lightning wallet. Using a wallet does not require delegating custody, so you keep full control over your keys. All you need to do is open a channel and transact with other users. The wallet will sort everything out in the background.
Suppose you want to pay at a local cafe. The first step is to transfer some BTC to a so-called multi-sig wallet — that is, a Lightning-compatible wallet that won't release the funds without several signatures or keys. For example, the Electrum wallet was among the first ones to support the network.
The wallets enable agreements within the Lightning Network. Any transaction creates a kind of a balance sheet, and the last signed balance sheet can serve as a reference in payment disputes.
You sign your balance sheet with your public key, so it reflects the final balances — the remainder of funds in your wallet and that of the cafe. When you stop buying from this merchant, you simply close the channel. The resulting balance sheet becomes a permanent record on the blockchain.
What merchants accept Lightning transactions?
Today, the Lightning Network directory includes over 200 businesses. It has a long way to go before entering the mainstream, but the number is growing steadily. The list includes cryptocurrency exchanges like Bitfinex, specialized online stores like ShopinBit, clothing retailers, gambling operators, hotel booking services, and more!
Pros and cons of Bitcoin Lightning Network
In contrast to Bitcoin's rigidity and high fees, the Lightning Network accommodates many more transactions in a faster and inexpensive way. Thousands of nodes route instant micropayments, allowing millions of users to send fractions of a BTC in a split second. There is no limit to the number of individual transactions within a channel.
This blockchain network is an ever-evolving concept, and it still has flaws — most notably, multiple fees and vulnerability to hacks and misuse. Whether the Lightning Network can dramatically improve decentralized finance depends on the research and development of the underlying technology.
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The information provided by CoinLoan (“we,” “us,” or “our”) in this text is for general informational purposes only. All investment and financial opinions expressed by CoinLoan in this text are from the personal research and open information sources and are intended as educational material. All outlined information is provided in good faith. However, we make no representation or warranty of any kind, express or implied, regarding the accuracy, adequacy, validity, reliability, availability, or completeness of any information in this text.