What is the Bitcoin Lightning Network and How Does It Work?

To overcome the inherent limitations of blockchain technology, various scalability solutions have been proposed to increase transaction volumes. In this discussion, we will discuss the Lightning Network, an extension of the Bitcoin protocol designed to overcome these limitations.

What is the Lightning Network?

The Lightning Network functions as an additional layer network on top of the blockchain, enabling fast peer-to-peer transactions. It is worth noting that this is not exclusive to Bitcoin, as other cryptocurrencies such as Litecoin have also adopted it.

You may be curious about the phrase "on top of the blockchain." Lightning Network is classified as a layer two or off-chain solution, enabling transactions without recording each transaction on the blockchain.

How the Bitcoin Network Works

Unlike the Bitcoin Network, the Lightning Network operates with its own nodes and software while still communicating with the main chain. Starting or ending an activity in the Lightning Network requires a special transaction on the blockchain.

The initial transaction involves forming a kind of smart contract with another user. These contracts, explained in more detail later, essentially establish a private ledger between the parties to a transaction. Multiple transactions can be recorded in this ledger, visible only to the party making the transaction, with integrated protection against criminal acts.

Called “channels,” these mini ledgers are created when, for example, Alice and Bob contribute 5 BTC each to a smart contract. After a series of transactions, the balance changes – Alice might pay 1 BTC to Bob, resulting in 6 BTC on Bob's side and 4 BTC on Alice's side. This process can continue, and at any time, the current state of the channel can be posted on the blockchain, allocating the balance to the parties concerned.

Lightning Network addresses the need for a more scalable Bitcoin blockchain. Implementing changes across such a broad ecosystem carries inherent risks, including the potential for hard forks and serious bugs. 

Conducting experiments outside of the blockchain increases flexibility and minimizes risk, ensuring the protocol's security assumptions remain intact. Users still have the option to continue on-chain transactions as usual, while gaining additional options for off-chain transactions.

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Some Benefits of Lightning Network

Below are some of the advantages offered by Lightning Network:

Scalability

The creation of Bitcoin blocks every ten minutes and the limited number of transactions per block creates a situation where users must compete to be included based on fees. The resulting fee fluctuations, sometimes exceeding $5 or even $50 during busy periods, pose challenges for small transactions like a $3 coffee checkout. 

Lightning Network introduced a dual fee system – one to open a channel and another to close it. Once the channel is open, however, many transactions can be made for free. 

The increasing adoption of off-chain solutions such as the Lightning Network ensures more efficient use of block space, enabling low-value, high-frequency transfers in payment channels.

Micro Transactions

A standard Bitcoin transaction has a minimum limit of around 0.00000546 BTC, about four cents. The Lightning Network goes beyond this limit, allowing transactions of up to 0.00000001 BTC, known as one satoshi.

This feature makes the Lightning Network more acceptable for microtransactions, offering convenience where regular transaction fees would be impractical. Some envision microtransactions replacing the subscription model, allowing users to pay a small amount per use of the service.

Privacy

The Lightning Network provides a higher level of privacy, allowing users to make transactions without exposing channel details to the network at large.

Even if the existence of a channel is visible on the blockchain, its internal transactions remain confidential if participants opt for privacy. Connected channels can create complex networks where the source and destination of funds are difficult to identify after the channel is closed.

Lightning Network Mechanics

Channels between nodes are fundamental to the operation of the Lightning Network. A multisignature address, involving multiple private keys, initiates channel setup. Participants contribute funds to a 2-of-2 multisig address, with both private keys required for movement of funds. Alice and Bob, the illustrative characters in this scenario, open a Lightning Network channel by depositing 3 BTC each to a shared multisig address.

This process involves a commit transaction, which represents an update to the channel ledger. The commitment ensures both parties can realign funds over the life of the channel. A unique mechanism, Hash Timelock Contracts (HTLC), enforces a contract between participants, allowing one party to take back funds if the other party acts uncooperatively.

Two incomplete transactions are exchanged, each displaying a multisig output with specific spending conditions. While the transaction waits for completion until the multisig is operational, secrets (As and Bs) are generated, hashed, and exchanged between participants. Commitment transactions are completed, with each party having a mechanism to recover funds if necessary.

Lightning Network prevents fraud through a punishment-based approach. If a participant tries to broadcast an old transaction, they risk losing their entire balance. This silences dishonest behavior, as the potential loss of funds serves as a strong barrier.

Payment Transfer

The Lightning Network allows the interconnection of channels, allowing the transfer of payments across multiple nodes. This feature ensures efficient and flexible payment channels, avoiding the need for users to open direct channels with each party.

Participants who facilitate payment switching may charge a fee, although this is not mandatory. Although the fee market within the Lightning Network has not yet fully emerged, it is expected to rely on liquidity-based fees rather than transaction value, as seen on the underlying blockchain.

Participants have local and remote balances in the channel, allowing funds to be “moved” in either direction. Liquidity dynamics influence route creation, with participants possibly sacrificing liquidity for fees, affecting the profitability of channel intermediaries.

Lightning Network Limitations

Despite its potential, the Lightning Network faces the challenge of simplicity. Bitcoin's inherent complexity, especially for beginners, is increasingly highlighted in the Lightning Network.

Currently, smartphone apps that support Lightning Network nodes often require access to Bitcoin nodes, complicating the user experience. 

Opening a channel, being a prerequisite for making payments, can be time-consuming and confusing for beginners. Continuous improvements aim to simplify the user experience and reduce barriers to entry.

Liquidity

The main criticism revolves around transaction constraints, which limit users to funds locked in channels.

Spending more than the locked amount requires closing the line or waiting for payments to come in, affecting network usability. Channel capacity and liquidity imbalances further limit the amount of funds that can be transmitted over the Lightning Network.

Centralized Hub

Concerns have been raised regarding the possible emergence of centralized hubs, large entities with substantial liquidity, facilitating the majority of transactions.

Such a scenario could compromise network robustness, with offline occupancy disrupting peer-to-peer connections and increasing the risk of censorship.

The Current State of the Lightning Network

As of March 2022, the Lightning Network has more than 35,000 nodes online, 85,000 active channels, and a capacity of more than 3,570 BTC. Diverse node implementations, including c-lightning, Lightning Network Daemon, and Eclair, contribute to its diverse ecosystem.

Conclusion

Lightning Network, launched on mainnet in 2018, has experienced significant growth, despite existing usability challenges. Ongoing development shows the potential for reducing barriers to entry, positioning the Lightning Network as an important component of the Bitcoin ecosystem, increasing scalability and transaction speed.

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DISCLAIMER: This article is informational in nature and is not an offer or invitation to sell or buy any crypto assets. Trading crypto assets is a high-risk activity. Crypto asset prices are volatile, where prices can change significantly from time to time and Bittime is not responsible for changes in fluctuations in crypto asset exchange rates.