What Is the Lightning Network?

Bitcoin Lightning Network
Hannah Scherwatzky / ONE37pm

When transacting on a blockchain-based cryptocurrency network like Bitcoin, the transaction times are slow and all-around inefficient. That’s why the Lightning Network exists.

The Lightning Network is a layer 2 decentralized payment protocol layered on top of blockchain-based cryptocurrencies like Bitcoin. It is intended to enable instant payments, scalability, lower costs, and cross-blockchain swaps.

What is Lightning Network?

What is the lightning network
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The Lightning Network was created to optimize the Bitcoin blockchain, while still maintaining a level of security found on decentralized blockchains. Below you will find exactly what the Lightning Network offers.

Instant Payments: Enjoy near-instant payments with the Lightning Network. Although fast, network security is still enforced by blockchain smart contracts without creating on-chain transactions for individual payments.

Scalability: The Lightning Network is capable of billions of transactions per second across the network. 

Low Cost: The Lightning Network allows for low costs because transactions and settling are done off-chain. 

Cross Blockchain Transactions: Cross-chain atomic swaps occur off-chain instantly with the same level of security. As long as the chains can support the cryptographic hash function, you can make transactions across numerous blockchains without the need for a 3rd party intermediary.

If Bitcoin is intended to be used on a daily basis for transactions all around the world, then it needs to have scalability. Considering the Bitcoin blockchain is only capable of around 7 transactions per second (Visa is capable of around 21,000 tps), then there needs to be a way to improve the tps, hence the Lightning Network.

The main reason for the existence of the Lightning Network is to increase the transaction speed of Bitcoin by creating a second layer of multiple payment channels between parties and Bitcoin users.

How does Lightning Network work?

How much are Lightning Network fees

The Lightning Network uses smart contracts and multi-sig scripts to execute. An initial transaction, called the funding transaction, is created when one or both parties fund a channel. Then, the two parties exchange a single key that is used to validate the transaction (aka commitment transactions) between themselves.

The two parties can execute countless commitment transactions between themselves and other nodes on the lightning network. Once the channel is closed, only then can peers exchange their master keys which facilitates access and spending of the funds.

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For example, say Nick likes to buy a coffee using Bitcoin every morning from the coffee shop, but, creating a transaction on the blockchain every day just to buy a coffee would be overkill and would get expensive. Instead, Nick decides to open up a payment channel with the coffee shop.

To do that, Nick and the coffee shop deposit a certain amount of Bitcoin into a multi-sig address (similar to a vault). Nick deposits 1 BTC, and the coffee shop deposits 0 BTC. The vault can only be opened if both Nick and the coffee shop agree.

Upon opening the payment channel, a balance sheet is also created to show how the funds in the address will be distributed. For now, it says Nick will get 1 BTC, and the coffee shop will receive 0 BTC. The main payment channel is opened on the blockchain for full transparency, that way the coffee shop knows that Nick has 1 BTC deposited in the multi-sig address.

Now that the channel is Open, Nick can purchase his morning coffee. Say a coffee costs 0.05 BTC. To pay for it, Nick simply subtracts 0.05 BTC from his balance and adds it to the coffee shop’s balance.

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Now the balance would say that Nick would receive 0.95 BTC, and the coffee shop would receive 0.05 BTC. Both Nick and the coffee shop would then sign the balance sheet upon approval of the changes, using their private keys.

They both get a copy of the updated balance sheet, and Nick can continue to order coffee for as long as he has a balance in the payment channel. There is no limit to how many transactions can be made between them considering it all happens off-chain. 

Of course, Nick or the coffee shop has the ability to close the payment channel at any time by broadcasting the current balance sheet to the Bitcoin network.

After miners validate the signatures and the balance sheet, the funds are distributed appropriately to both Nick and the coffee shop, all using a single transaction on the main Bitcoin blockchain.

So essentially, only two transactions occur on the Bitcoin blockchain, one to open the channel and one to close it. This saves time, money, and congestion on the blockchain.

What are the fees for using Lightning Network?

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There are two kinds of fees for using the Lightning Network, the base fee, and the fee rate. The base fee is charged for each forwarded Hash-Time-Locked-Contract (HTLC), regardless of the payment size. The fee rate is the proportional fee charged based on the value of each forwarded HTLC. 

Fees can only be charged for successful payments because the fees are included in the payments, and all HTLCs are dependent on the same function. Also, fees are applied only once per peer and per channel.

Each peer can set their fee policies for all their channels, which are applied to the capital in the outgoing channel in the event of a forward. 

That means when you push a payment to your neighbor node, you are able to charge a fee, and as payments are sent to you, your neighbor charges the fee, even if it’s your channel. Also, if your capital is depleted in a channel, you get to charge the fee.

To learn more about Lightning Network’s fees, check out their official Builder’s Guide.

Pros of the Lightning Network

How does Lightning Network work
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The Lightning Networks has several pros, including:

  • Speedy transactions

The Lightning Network does a great job of completing transactions extremely quickly from peer-to-peer. You don’t have to wait for block confirmations or nodes to verify the transaction, smart contracts oversee everything via a multi-sig wallet.

  • No minimum payments

No matter how small your Bitcoin transaction is you can send it peer-to-peer for a cost-effective fee. All transactions are processed immediately.

  • Reduced fees

Whether you are looking to make a small translation or a large one, you don’t have to incur outrageous transaction fees.

  • Completely Annonymous

All Bitcoin transactions done within a mini-ledger channel are completely anonymous and encrypted. Only once a channel is closed, all transactions are completed and signed for, then recorded onto the Bitcoin blockchain.

Cons of the Lightning Network

Cons of the Lightning Network
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Of course, there are some cons to using the Lightning Network as well, such as:

  • No offline support

This likely comes as no surprise, but to use the Lightning Network requires that you have a stable internet connection. No internet, no Lightning Network.

  • Must rely on your peer

Due to the peer-to-peer nature of the Lightning Network, the buyer relies heavily on the seller to transfer the funds. If your seller is unresponsive, you won’t be able to complete the transaction.

  • Reduced fees could damage the longevity of the Bitcoin blockchain

After all the Bitcoin has been mined, transaction fees will be the only financial reward for miners overseeing the blockchain. Without mining fees, Bitcoin’s longevity could be in question.

The Lightning Network continues to offer a cost-effective solution for those who want to transact using Bitcoin. But, with this end up causing more issues in the future? Only time will tell for sure.

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