lightning network

We can all agree that the development of cryptocurrency has led to advancements in the way we transact money. It’s no longer just a physical task; you now have the option of doing it digitally. With that said, there are a few limitations to the process concerning both the speed and the attachment of fees. Is there a way we can send cryptocurrency instantaneously and without a fee? This is where the subject of ‘lightning network’ comes into play. This article will explain this concept and the potential it holds for transactions.

What is it?

The Lightning Network is a second layer technology built specifically for bitcoin. It uses micropayment channels in order to scale the blockchain’s ability to carry out transactions. By removing transactions from the main blockchain, the expectation of the Lightning Network is to decongest bitcoin. In addition, the network reduces transaction fees in association with the system. Transactions that go through on the Lightning Network are instantaneous. Additionally, the technology will enhance bitcoin’s utility as a medium for daily usage.

The Lightning Network also aids in executing off-chain transactions involving exchanges between other cryptocurrencies. For instance, they are a necessary component for atomic swaps. In this case, the technology allows one cryptocurrency to exchange for another without needing an intermediary, such as a cryptocurrency exchange.

Joseph Poon and Thaddeus Dryja proposed the concept of this Network in 2016. These developers made significant advancements to Satoshi’s original design by way of proposing a decentralized network of lightning-fast transactions. The Network is currently still under development. The original problem, as they saw it, was that for bitcoin to officially become a method of daily transactions, it would have to process millions of transactions per day.

This, however, raised a problem. The nature of bitcoin’s technology requires consensus from each and every node within its network.

Relation to Bitcoin

Investopedia editor, Jake Frankenfield, provides an example of this issue:

“…approving and storing transactions will become expensive and time-consuming if their numbers on bitcoin’s network multiply. An increase in transaction numbers also requires orders of magnitude improvement in the processing power of computers, whether they are situated at home or work, that are required to execute transactions involving bitcoin.”

Let’s face it: while bitcoin offers an abundance of solutions to problems existing in our money system, it still has drawbacks. The limitations concerning the speed and price of transactions – especially during busy times – is just one of those drawbacks. Issues like this are what keep bitcoin from achieving peak perfection and being a true medium exchange for daily microtransactions.

This is where the Lightning Network comes in. The purpose of its second layer design was to solve this particular issue. That second layer consists of various payment channels in between parties or bitcoin users. A Lightning Network channel is basically a transaction mechanism that exists between two parties. By using channels, the parties can both make and/or receive payments from each other.

Transactions, however, are processed differently in comparison to standard transactions occurring on the bitcoin blockchain. They only experience updates on the main blockchain whenever two parties open and close a channel.

To further illustrate this concept, let’s dig a little deeper into the scalability issue of bitcoin.

The scalability issue

As previously mentioned, bitcoin has its limitations despite the solid reputation it has built up over the years.

If you try to send a transaction during a very busy period of time, you will notice something happen. The transaction will not only get slower but it will also become more pricey. Transactions get a confirmation from miners only once every 10 minutes on average. If you fail to attach a high enough fee, it can take a long time to be confirmed.

This, of course, means that the current form of bitcoin is not scalable. To elaborate, scalability is a component of a system, model, or function that describes its capability to cope and perform well under an expanding workload.

A system that scales adequately will be able to maintain (even increase) its performance level or its efficiency. All of this happens even as it is put to the test by larger operational demands. In finances, scalability refers to financial institutions’ ability to deal with increasing market demands. In the corporate environment, a scalable company maintains or improves profit margins while sales volume grows.

Investopedia editor, Will Kenton, explains that:

This concept is closely related to the term economies of scale, wherein certain companies are able to reduce their production costs and increase profitability as they grow larger and produce more. For situations when increasing production increases costs and lowers profits, it is called diseconomies of scale.”

So, while Visa is able to process 65,000 transactions per second, bitcoin can only handle 7 per second. With additional upgrades, this number could potentially increase to double digits. Regardless, it is not even close to matching the speed of traditional payment processors.

Do we switch to altcoins?

Unsurprisingly, this turns into a serious issue with daily microtransactions. One of the primary arguments of why bitcoin cannot be a medium of exchange is due to how slow it is. Furthermore, it is expensive to send small payments through the network.

Because of all that has been said, some altcoin backers will argue that this means we should drop bitcoin and use another cryptocurrency. While this may sound logical, it is not a very wise idea for the following reasons:

  • Some altcoins are sketchy and only want your bitcoin in exchange for a ‘shitcoin’ (a worthless altcoin).
  • No coin garners as much acceptance and trust as bitcoin.
  • If their coin reaches bitcoin levels of popularity, it can potentially run into the exact same limitations. An example of this is what has become of Ethereum.

A possible solution

By now, it should be clear as to what the Lightning Network can conceivably – and needs to – fix. It has been designed with a set of rules specifically tailored to facilitate micropayments. If bitcoin is layer one than the Lightning Network is layer two. In essence, the Network is capable of connecting its users to a system that is “fast and feeless.” This is done by way of a routed series of transactions and with it, we basically get bitcoin without the drawbacks.

With context provided, we can now go further into how exactly this Network functions. The most basic concept behind it is payment channels.

How does it work? – Example #1

Let’s say you want to transact with your friend. To do this, you open an off-chain payment channel between the two of you. From this point onward, the payment channel is officially open and any number of transactions can occur. This will all happen without payments ever coming into contact with the main blockchain.

Because of this system, you can transfer funds as quickly as wallets can communicate over the net. When the time comes to conclude business, you and your friend conduct a ‘closing transaction’ on the main blockchain. This will effectively settle all of your previous transactions. You and your friend essentially track how much each one owes the other without ever exchanging money. This is until you both choose to settle the bill.

However, unlike this example, there are cases where you won’t be transacting with a friend. A good chunk of the time you are transacting with a complete stranger. This begs the question, “How can I trust that the person who owes me money won’t just run off?” There is, in fact, a simple answer for this.

How does it work? – Example #2

When you open up a payment channel, you each deposit a certain amount of money. This will act as a form of security deposit. The total amount of this deposit has to be equal to or higher than the transacted value. Here is an example that will help better explain this.

You and your friend want to carry out a series of bets with a total volume of a singular bitcoin. Predictably, you open an off-chain payment channel and you each deposit 0.5 BTC as a security deposit. To be technical, you both send an amount of 0.5 BTC over the layer one blockchain to a multi-signature (aka. ‘multisig’) bitcoin address. This allows bitcoin miners to process and validate the layer one transaction.

This deposit is the only payment that will actually “reach” the layer one blockchain. From here, the smaller payments go through a settlement between you and your friend via the Lightning Network’s payment channel.

It’s important to remember that if either of you wants to back out of the transaction, you can. You are able to take your deposit and leave without consulting the other person. That being said, a one-sided withdrawal will force the other person to wait for 1,000 block confirmations (roughly one week) to get the deposited currency back. The party that is left behind will promptly receive the bitcoin back.

Losing a bet

Let’s now assume that you lost a bet and need to pay your friend 0.1 BTC. Both of you will sign a transaction in your off-chain ledger. This states that you now have 0.4 BTC and your friend has 0.6 BTC. If your friend wants to leave with the winnings, they can display the ledger to the network. This will result in the deposits returning according to the new balances. This closing transaction will happen on layer one of the Network.

The Lightning Network also contains fraud protection mechanism within their system. If for any reason you were to try to back out without paying 0.1 BTC and take your whole 0.5 BTC back, the whole deposit (i.e. 1 bitcoin) will be sent to your friend. There are penalties set in order to discourage participants from attempting to cheat.

Keep in mind, even if the two of you transact over 1,000 times, the blockchain will only display two transactions. One for opening up the payment channel and depositing money, the other for closing it and settling the bill. All of the transactions that exist in between were pretty much feeless and immediate.

lightning network

Channels

So now you understand how the network works, but you are probably asking something else. “In order to make transactions, do I need to deposit funds with each new person I interact with?” Clearly, that is not a realistic concept.

In order for bitcoin to become the quintessential alternative for cash and credit cards, something must be done. We need to be able to conduct efficient and feeless payments with complete strangers and without making such deposits every single time. If we want to overcome this problem, the Network will allow us to “jump” through connecting payment channels.

Network channels permit the indirect connection of payment channels by way of intermediaries. What this means is if you and your friend have a payment channel, and your friend has a channel with their sibling, you can ask them to pay their sibling on your behalf. This is done by using their own open payment channel. You then pay your friend back the moment that they provide proof they did so.

This makes the Lightning Network a much more powerful system. To transact with someone, all you need is to find a path to that specific person. The way to do this successfully is through other participants in the Network who already know each other. This is regardless of whether or not the channel goes through a wide variety of intermediaries. It is because of this that the Network is globally scalable.

‘Hub-and-spoke’ model issue

If you recall from earlier, the Lightning Network is still under development. This leads to the system having its fair share of issues as well. However, it’s important to mention that they are in the process of resolution.

The most glaring problem is that decentralization may lead to a replication of the ‘hub-and-spoke’ model. Penske (a truck rental company) explains what this model is by using their services as an example:

To deliver products in the most cost-effective and timely means possible, forward-thinking logistics companies are embracing hub-and-spoke models, where connections are arranged like a wheel. Freight traffic moves along spokes connected to a central hub. This efficiently moves products out of strategically located distribution centers and shortens travel time.”

This is essentially what characterizes the financial system nowadays. In that model, banks and financial institutions are the primary intermediaries through which all transactions occur. Frankenfield writes, “By virtue of having more open connections with others, lightning nodes for prominent businesses may become similar hubs or centralized nodes in the network. A failure at one such hub could easily crash a significant portion of (or the entire) network.”

Other issues

The second problem is one that is actively being investigated. It is the possibility of an increase in bitcoin transaction fees. They are a vital component of the Network’s overall fees. Suppose bitcoin’s transaction fees were to rise. That would make the second layer redundant since it would become cheaper to conduct transactions on the Bitcoin Blockchain.

The final issue – one that is less arduous to explain – is the Network’s vulnerability to hacks and thefts. This is because when utilizing the Lightning Network, it’s a lot like storing crypto in a hot wallet. However, several wallets specifically for the Lightning Network have emerged.

The future of the Lightning Network

With the Lightning Network, a lot of new payment models will become a reality. There could very well be a system of payment that can reach anyone in an instant with absolutely no overhead. Similar to the impact audio and video streaming has had on the mainstream, there is the potential of the emergence of an era of streaming money. Moreover, imagine that instead of waiting for the bi-monthly period to get a paycheck, you are paid every second you work.

All in all, there are numerous potential uses for the Lightning Network. It is a beneficial idea that, with a bit of tweaking, can lead to brand new innovations in cryptocurrency transactions.

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