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What Is the Lightning Network in Bitcoin and How Does It Work?

Sunflower Corporation· 7 min read

The project is intended to scale bitcoin and provide faster and less expensive transactions of the first cryptocurrency than the basic mainnet. The fee for transferring LN is one satoshi (0.00000001 BTC).

The project has been criticized for providing insufficient economic incentives to maintain the network and for providing less anonymity to users than the bitcoin blockchain.

Why do we need Lightning Network?

Bitcoin’s throughput is about 7 transactions per second (TPS), and the time between new blocks is about 10 minutes. Such relatively low scalability rates were the result of the bitcoin creator’s solution to the blockchain trilemma, which involves finding a balance between the three characteristics of the network: decentralization, security and performance.

The current performance of bitcoin does not allow it to compete with centralized payment solutions such as Visa, whose system is capable of processing 65,000 TPS, as well as modern blockchain platforms such as Solana, which can process up to 400,000 TPS.

As a result, a second-level Lightning Network solution is a necessary compromise to maintain the decentralization and security of the main network layer by adding a faster and less expensive second layer.

According to data as of September 30, 2022, the average daily commission on the bitcoin network has not risen above $5 per transaction since the summer of 2021. In the Lightning Network, the transfer fee is 1 satoshi (0.00000001 BTC) — $0.0001 with the bitcoin price at $20,000.

Theoretically, LN scaling is unlimited. According to Lightning Network developer Joe Kendzicky, the maximum capabilities of LN are estimated at millions of operations per second.

How does Lightning Network work?

The use of payment channels is a key principle of the Lightning Network. This is a multisignature wallet that stores a predetermined amount of bitcoins. Coins can be provided by both sides or by just one.

A regular bitcoin transaction is used to open the channel. Its information is stored in the blockchain, and bitcoins are “blocked” for LN. In the future, all transactions conducted within the channel will take place directly between participants outside the blockchain. The channel’s maximum transfer amount cannot be greater than the blocked amount.

The Lightning Network channel is essentially an analogy for a safe, in which money is stored and made available to a select group of people in the future. However, if you need to know the digit combination to open the safe, private keys are used in the case of LN.

  Dynamics of the number of Lightning Network channels. Source: Bitcoin Visuals

The example of using Lightning Network

Here’s how LN is used in practice: Alex’s favorite coffee shop has announced that it will now accept bitcoin as payment. However, paying for a cup of coffee in BTC every time is prohibitively expensive due to the high fees. Furthermore, it takes time to confirm the transaction.

LN can fix it. Alex creates a payment channel between himself and the coffee shop and deposits 0.001 BTC into it, which he will spend later on ordering coffee. When you create a channel, 0.001 BTC is displayed on Alex’s balance and 0 BTC is displayed on the coffee shop’s balance.

Assume the cost of a cup of coffee is 0.0003 BTC. Following the first order, 0.0007 BTC will remain at Alex’s LN address, while 0.0003 BTC will remain on the coffee shop’s balance. As a result, Alex can order coffee until his balance is reset to zero or he closes the channel. With each transaction, Alex and the coffee shop sign an updated contract indicating how many coins are owned by each party in the channel. The bitcoin blockchain does not store data; instead, each party stores its own copy of the contract.

The Lightning Network is organized in accordance with the network principle. This means Alex may not have an open payment channel with the coffee shop, but he may be connected to him via other channels.

That is, users can exchange LN transactions with any other users who are linked to their payment channel network via nodes.

The financial incentive for establishing such connecting nodes is the receipt of small commissions each time a transaction occurs via one of the channels connected to it.

The Lightning Network architecture does not require the parties’ trust due to the use of smart contracts. Funds are always routed through intermediaries or returned to the sender if an indirect path to the recipient is not possible for whatever reason.

Which wallets support Lightning Network?

By the fall of 2022, there are already a number of bitcoin wallets on the crypto market that allow you to open channels and make transactions of the first cryptocurrency through LN. For beginners, such options as Blue WalletWallet of Satoshi or Nicehash are suitable. More advanced users can choose MuunBreezPhoenix or Zap.

The Lightning Network history

The concept of payment channels was proposed by Satoshi Nakamoto in 2009, providing the community with an outline of the code, which assumed the creation of special channels between users. In 2013, bitcoin developer Mike Hearn published a letter to Satoshi detailing these mechanisms.

In February 2015, Bitcoin developers Joseph Poon and Thaddeus Dryja published the first unfinished white paper of the LN paper ”The Bitcoin Lightning Network”. At the beginning of 2016, the main version of the LN whitepaper was released.

Due to the decentralized nature of LN development and the many independent development teams, the community had to create common implementation standards. The foundation of “standardization” was laid at the summit in Milan in October 2016.

In August 2017, the Segregated Witness soft fork was activated on the bitcoin network, a necessary update for the further implementation of the Lightning Network.

The test version of the LN client was released in March 2018 by the Lightning Labs team. At that time, more than 1,000 nodes were already operating in the network and 1863 channels were opened.

As of September 29, 2022, according to the 1ml service, LN has 17,829 nodes and 86,282 payment channels with a total network capacity of more than 4,900 BTC (about $94.6 million).

  The total capacity of the Lightning Network in bitcoins (in red) and dollars (in blue). Source: Bitcoin Visuals

The Lightning Network ecosystem

In 2021, analysts of the research company Arcane Research noted the exponential growth of the LN ecosystem due to the legalization of bitcoin in El Salvador, where the Chivo crypto wallet compatible with this protocol is used at the state level.

  Source: Twitter

In February 2022, the country’s authorities restarted Chivo, improving the user interface of the application, fixing bugs and adding improved LN support.

Transfers to the Lightning Network are supported by many centralized cryptocurrency exchanges, including Kraken, Bitfenix, OCX and OKCoin.

Venture capital firms are showing an interest in the development of the LN-based payment solutions sector. Strike, a Lightning Network-based payment application operator, successfully raised $80 million in funding in September 2022. The startup is working on an app that will allow users to buy bitcoin through LN as well as make transfers within this network.

  Projects and companies included in the Lightning Network ecosystem. Source: Coinbase

In February 2022, analytical firms also expressed interest. The Chainalysis platform added Lightning Network support to its transaction tracking solution.

Leading financial institutions are gradually incorporating LN into their services. Online broker Robinhood announced plans for LN integration in the spring of 2022, and MicroStrategy included the development of a wallet, server, and authentication options using the Lightning Network in the plans.

There are projects that allow tokenization of assets and even the issuance of stablecoins for use in LN-based applications. The Lightning Labs team announced the corresponding initiative in September 2022, presenting the alpha version of the Taro protocol.

Why is Lightning Network criticized?

A number of issues and potential vulnerabilities in the LN protocol have been identified by experts. One of them was discovered in 2020 by bitcoin developer Joost Jager: some payment channels were unable to make more than 483 micropayments and thus blocked BTC for up to two weeks. Furthermore, the Lightning Network described potential fraud opportunities with payment channels.

According to the Shinobi technical expert, the Lightning Network architecture has serious flaws: the network cannot develop due to a lack of significant economic incentives. According to him, the routing fees collected by LN nodes are insufficient.

An important remark to LN was made by an analyst under the pseudonym “Zem”, noting anonymity as one of the key problems for the adoption of technology.

The researcher also believes that because the technology does not comply with financial laws, decisions based on it will be difficult to obtain approval from organizations such as the Financial Crimes Enforcement Agency in the United States (FinCEN).

The Ethereum platform developer community has also criticized LN. Anthony Sassano, the founder of the EthHub blockchain project, compared LN to fax machines from the past, claiming that the Rollups technology used to scale the Ethereum network is the best option.

  Source: Twitter

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