Lightning Network Explained

Lightning Network Explained

The Lightning Network is a layer two protocol being built on Bitcoin (BTC) with the aim to help the leading cryptocurrency scale.

Bitcoin is touted as the future of money and the backbone of the world’s financial system, but to achieve this it has to scale.

With decentralization comes the problem of scalability, and at seven transactions a second Bitcoin is no where near anything it promises to be.

Layer two scaling solutions such as Lightning Network are being created, however, and it’s expected that once it is fully operational, everyday payments with BTC will be a seamless and cheap option.

Why The Lightning Network Is Needed

Transactions on the Lightning Network are off chain transactions, and are not picked up by the Bitcoin miners and will not be added to transactions on the blockchain, thus freeing up space for bigger on-chain transactions.

For any currency to be a mainstream exchangeable asset, it has to be able to scale. VISA is an application on fiat currency and it’s believed it can handle 65,000 transactions per second.

Obviously, at 7 transactions a second Bitcoin is lagging way behind VISA. That’s because of the decentralized nature of Bitcoin.

Every transaction on Bitcoin is picked up and hashed by miners, who are decentralized around the world. They hash them into the blocks, send them onto Nodes, who validate the transactions, before letting miners fight it out with each other to be the one to add the latest block onto the blockchain.

VISA processes everything on their centralized database, and this efficiency is what any true decentralized blockchain cannot compete with.

That said, centralized databases such as VISA cannot compete with the integrity of Bitcoin’s monetary policy, the security of the Bitcoin Network, or the cost of BTC transactions on the Lightning Network.

There has been a lot of debate about Bitcoin and its scaling issues. Back in 2017 there was debate among the community as to whether Bitcoin should increase the block size from one megabyte, and with it an increase in transactions speed.

It was decided among the Bitcoin community not to increase the block size, and so a hard fork saw the creation of Bitcoin Cash (BCH), which it’s believed can handle 61 transactions per second.

Still, nowhere near enough, and the bigger block size would have compromised the security of Bitcoin, so it really wouldn’t have been worth it.

Lightning Network is a layer two payment gateway built on top of Bitcoin, with the main purpose to handle every day transactions such as buying a coffee, or going to the supermarket.

Transactions on the Lightning Network will take place in a matter of milliseconds, and it will be able to handle billions of transactions a second. This introduces miniscule fees of fractions of a penny, which will also facilitate the idea of microtransactions, something that will be essential as the Internet of Things (IoT) roles out.

How Does Lightning Network Work?

Let’s use Bob and his favourite coffee shop as a case study. Bob goes to his favourite coffee shop on his way to work and buys his morning coffee. If he was to pay for it on the Bitcoin blockchain, his transaction fee wouldn’t make it worth it.

However, with the Lightning Network, Bob can set up a payment channel with the coffee shop to pay. To do this, both Bob and the coffee shop deposit a certain amount of BTC in what is known as a multi signature (multi-sig) address on the Lightning Network.

Let’s say Bob deposits 0.001 BTC in the payment channel and the coffee shop deposits nothing. The multi-sig will act like a safe between the two parties and transactions within the channel can only be executed when both parties sign.

When a payment channel is created on the layer two protocol, a balance sheet that explains how the funds in the address should be distributed is opened up. So at the moment of Bob and the coffee shop creating the channel, Bob would get 0.001 BTC and the coffee shop wouldn’t own any of the BTC in the channel.

The payment channel is stored on the Bitcoin blockchain, so there is full transparency among both parties. The coffee shop owner can then verify that Bob has enough value in the channel and will receive payment for anything Bob buys.

With the channel now open, Bob can order his morning coffee. Now, let’s say the coffee costs 0.0005 BTC, Bob would simply subtract the amount from his balance sheet and add it the the balance sheet of the coffee shop, both on the Lightning Network.

Once done, the updated balance sheet will say that both parties now own 0.0005 BTC on the payment channel. Bob and the coffee shop then both sign it with their private keys, and the transaction will take place.

How To Get Your BTC

Bob can do this as many times as he likes, considering he has enough BTC in the channel to pay. They can make as many transactions among each other as they like, there is no limit.

As long as there is value a transaction can take place, no matter how little value it is. The BTC will remain in the channel until either Bob or the coffee shop decide to cash out.

If either party decides to cash out, they simply take the latest balance sheet, and broadcast it to the Bitcoin network. Miners will then validate the signatures on the balance sheet, and if everything is above board, the funds will be released according to the balance sheet.

No matter how many transactions were on the layer two payment channel, once it’s broadcast to the network, it will create only a single transaction on the Bitcoin blockchain, thus significantly reducing congestion on the main chain

Do You Have To Create a Payment Channel With Everyone?

The idea of opening a channel with every person or business seems like a headache. You can open as many payment channels as you like, and it’s a good idea to open one with somebody you transact regularly with. Just like Bob and his favourite coffee shop.

But let’s say Bob’s friend Alice is up from London for the day, and it’s her first time at the coffee shop. It’s pointless her creating a channel with the coffee shop just for one coffee.

The beauty of the Lightning Network means she doesn’t have to.

Let’s say Alice and Bob are good friends and have their own payment channel, that they use among their friends’ group. Alice wants to buy Bob and herself a coffee. So, rather than opening up a new channel with the coffee shop, she can just forward it to Bob, who can then forward it to the coffee shop.

And it can all be done in a matter of seconds for a fraction of a penny.

The Lightning Network Will Help Bitcoin Scale

Bitcoin is such an exciting innovation. A store of value it is definitely becoming, but it really wants to become a peer-to-peer payment system.

This will take a while before its being done at scale because of the volatility of the Bitcoin price. The cost and speed of transactions on the Bitcoin blockchain also makes it improbable for now.

But this is where the Lightning Network comes in. The layer two protocol allows anybody to pay anybody, however little, at scale. It’s still in its very early days, but more channels are growing on the Lightning Network.

VISA charges merchants a few percent for every transaction, and it’s you and me who pay for that. Lightning Network will pretty much eradicate these fees, and once the Bitcoin price stabilizes more people and businesses will turn to Lightning Network.

Why wouldn’t they? It’s much cheaper and more secure than systems like VISA.

Author: Tommy Limpitlaw

Bitcoin FAQs

What is the point of Bitcoin?

Bitcoin is a decentralized money. A money that nobody can control or manipulate, and a money that nobody can print and devalue. It’s also not necessary for any third party to verify transactions, so it makes it much faster and cheaper to send value. It’s also money built on the Internet: a society of almost 5 billion people.

Can you lose money on Bitcoin?

You certainly can lose money on Bitcoin. Many new investors see the gains Bitcoin has made and expect it to always be so. But the truth is, Bitcoin’s gains have come from buying Bitcoin and holding on long term and riding the market. People expecting only gains, quickly lose faith when it crashes and lose money. The best way to avoid losing money is buy Bitcoin and hodl.

Why should I buy Bitcoin?

People who understand Bitcoin buy Bitcoin because it is a peer-to-peer money that nobody can manipulate. It’s all set in the Bitcoin codebase which is secured by hundreds of thousands of computers all around the world. Bitcoins can be sent by anybody and no third party is need to verify the transactions, and nobody can stop Bitcoins being sent. There are many more reasons why people buy Bitcoin, and a deeper dive before doing so is recommended.

Can you buy less than 1 Bitcoin?

Yes. Every Bitcoin can broken down into 100 million bits. They are known as satoshis, after the pseudonymous creator Satoshi Nakamoto. And some companies will let you buy as little as $1 worth of Bitcoin, which at time of writing is worth about 11,000 satoshis. There are many companies that have a system for dollar cost averaging (DCA). This is a great way to buy Bitcoin, and is known in the space as ‘Stacking Sats’. Basically, what you do is set up small automatic, recurring payments to buy Bitcoin (or sats), and you DCA over time.