Gareth Johnson
Gareth Johnson
Updated on September 16, 2021

Many people believe that crypto is the payment method of the future but for retailers and merchants to embrace it to its fullest, crypto networks need to find solutions for two codependent problems: slow transaction speed and scalability. 

These issues weren’t easy to spot or predict in the early days of Bitcoin, but in recent years, with the great surge of new users and the increased Bitcoin adoption across the world, the time it takes to verify a transaction has become a bit of a problem in the Bitcoin community. Enter the Lightning Network

The term Lightning Network may sound like it came straight out of a sci-fi movie, but in reality, it’s just another one of those fancy blockchain inventions that developers are currently working on. If all goes well as it does in theory, this might be the key to open the gates of the modern scalable crypto universe.

Keep reading this article to find out the foundations of this network, the reasons for its creation, its applicability, and its future potential.

What Is Bitcoin and How Does It Work?

First of all, we should really cover the basics of cryptocurrencies and crypto transactions. 

Bitcoin (BTC), the world’s first cryptocurrency, is an open-source digital currency that operates on a peer-to-peer network. Bitcoin was created in 2009 by an anonymous inventor going by the name of Satoshi Nakamoto, though it’s probable that this isn’t a single person but a whole team of developers instead. 

Bitcoin is completely decentralized and isn’t influenced by any central authorities like banks or governments. It is created, distributed, traded, and stored by the use of a decentralized public ledger system called the blockchain.

Bitcoin on the moon's surface with planet earth on background

The Bitcoin system runs on a group of computers that run its code and store the blockchain. Those groups are called nodes. The blockchain is a collection of blocks, and each of these blocks contains a group of transactions. Each block can fit a limited number of transactions and once filled, it is added to the existing chain of blocks. 

Bitcoin was created and designed to operate as peer-to-peer digital money. Whether you use it to receive or send BTC it’s important to understand how transactions work. You can think of Bitcoin transactions as messages that senders digitally sign using cryptography and send them to the Bitcoin network to be verified. All transactions are public and stored on the blockchain. Every transaction can be traced back to the origin of the exchanged coins due to the network transparency.

Prelude to the Lightning Network

When Bitcoin was first introduced, the first public comment on this new system was from a certain James A. Donald. The comment read: “The way I understand your proposal, it does not seem to scale to the required scale.” Almost a decade later, the same problem still endures, the lack of transaction scalability.

Namely, in all of Bitcoin’s time in this world, it has only been able to process 7 transactions per second. This might have been enough in the early days but now the system is congested, and as a result, not only do transactions take more time to process but transaction fees are growing too. 

If Bitcoin is ever to become a globally accepted payment method or an alternative to existing traditional payment systems, it will need to improve its scalability. To put it in plain words, when you compare Bitcoin’s 7 transactions per second (TPS) to Visa’s average speed of 24,000 TPS, while achieving 50,000 TPS at its maximum capacity, you will understand the urgency of the problem. 

Over the last decade, Bitcoin users and developers have brainstormed different proposals on how to improve the scalability of the system, and an optimal solution is yet to be found. However, there is one proposed solution that they’re currently working on, and it might be the one solution to solve them all. This solution is called the Lightning Network.

What Is the Lightning Network?

The Lightning Network functions as a brand new second-layer technology that cryptocurrency networks can apply to their blockchain and improve their scalability. The way it does this is by using micropayment channels to scale the blockchain’s ability to conduct transactions quickly and efficiently.

Lightning technology was first mentioned in a white paper published by Joseph Poon and Thaddeus Dryja in 2015.

Presently, there are three different teams that work together on the development of the Lightning Network: Lightning Labs, Blockstream, and ACINQ. Each of these development companies is using a different programming language to develop their own version of the Lightning Network protocol.

Hand reaching out for holograph concept of lightning network on dark background

For instance, Lightning Labs are working on their version called Lightning Network Daemon (LND) in Golang; Blockstream is developing their version in C, and ACINQ is working on a Scala programming language implementation.

The Lightning Network relocates transactions from the main blockchain, thus making them off-chain. This helps decongest the Bitcoin blockchain and reduce the transaction fees. The transactions on the Lightning Network are much faster, cheaper, and more effortlessly confirmed when compared to the transactions on the blockchain, referred to as on-chain transactions.

The Lightning Network can also be used to conduct different types of off-chain transactions with crypto exchanges between different cryptocurrencies. As an example, it can be used to enhance the process by which atomic swaps enable the exchange of one cryptocurrency for another without the need for intermediaries like cryptocurrency exchanges.

What Are Atomic Swaps?

Atomic swaps are a type of smart contract technology that allows the exchanging of one cryptocurrency for another while eliminating intermediaries such as crypto exchanges.

Atomic swaps can transpire directly between the blockchains of different cryptocurrencies or off-chain. They were first implemented in 2017 when an atomic swap was carried out between Litecoin and Decred.

The problem with exchanging coins on a crypto exchange is that not every platform accepts every single coin. So, if a crypto trader wants to exchange their coins for ones that are not supported by the exchange of their choice, they’ll need to change accounts or make numerous conversions between intermediate coins in order to achieve their goal. 

Atomic swaps solve this issue by using Hash Timelock Contracts or HTLC. HTLC stands for a time-bound smart contract between two parties that concerns the cryptographic hash function that they need to generate and verify.

However, it’s essential for atomic swaps that the two parties acknowledge the receipt of funds within a designated time frame using a crypto hash function. If by any chance one of the involved parties is unable to confirm the transaction within the given time frame, the whole transaction is deemed invalid, and no amount of Bitcoin or other crypto is exchanged.

The Need For the Bitcoin Lightning Network

In order for Bitcoin to achieve its full potential and become a legit medium for everyday transactions, it has to be able to process thousands of transactions per second, similar to how credit cards and electronic payment networks operate. On account of the nature of the decentralized blockchain technology that demands consensus from all nodes, the Bitcoin network is plagued with problems in its current shape.

For example, if the number of transactions grows rapidly, it will both take longer and cost more to record and verify the transactions. Moreover, this increase in transactions will require more processing power, which would make Bitcoin mining super expensive.

The Lightning Network brings forward solutions for the scaling problem by implementing a second layer on the blockchain of Bitcoin’s network. This second layer is composed of various payment channels between different Bitcoin parties and users. The Lightning Network channel acts as a translation device between the involved parties, and through these channels, they can make or receive payments.

Hand holding bitcoin with lightning on background

This is different from the standard transactions that occur on the main blockchain. The Lightning Network transactions are updated on the main blockchain only when the channel is opened and closed. Between the opening and closing of the channel, the parties can transfer funds between themselves without the need to announce their presence on the main blockchain.

This increases the transaction speed because the transactions don’t have to be verified by all network nodes. Payment channels between different parties merge and form a network of lightning nodes that can conduct direct transactions between them. These interconnections between different payment channels are what the Lightning Network consists of.

How the Lightning Network Works

Let’s imagine that a woman named Alice opens a payment channel with her favourite smoothie bar and deposits $50 worth of Bitcoin in it. The transactions with the smoothie bar are instantaneous because Alice has a direct channel and the transactions are directly updated on the blockchain through this channel.

A man called Bob has an open channel with the tobacco store he often shops in and is also a regular customer at Alice’s smoothie bar. The connection that links Alice, the smoothie bar, and Bob, ensures that Alice can use assets from her balance with the smoothie bar to buy vanilla flavoured-cigarillos from the store that Bob shops from. In the same manner, Bob can use his tobacco store balance to carry out transactions with shops in Alice’s network.

If it wasn’t for Bob and his channel with the tobacco store, and if there were no other mutual customers between the smoothie bar and the tobacco store, Alice would have had to open a new channel with the tobacco store in order to shop there. This is the manner in which a mesh of transactions is created and dispelled among multiple lightning nodes in a decentralized manner.

On a more technical tier, the Lightning Network uses smart contracts and multi-signature scripts to execute the transactions. The initial transaction, also called a funding transaction, is established when one, or all of the parties included, fund a channel. In a regular multi-signature habitat two master keys are exchanged (one is public, while the other one is private). This exchange provides access to the funds and the option to utilize their spending. 

In the case of lightning nodes, no signatures are exchanged. The reason for this is to stave off the main blockchain from recognizing the funding transaction. The way it works is the two parties exchange a single key which is used to prove the spending transaction among them.

Fees In the Lightning Network

The Lightning Network incurs a small transaction for these types of payments. The fees are a mix of routing fees for routing payments among the lightning nodes and the Bitcoin open and closed channels fee. The minimal fee costs around one satoshi, or about 0.00000001 BTC. When compared to regular Bitcoin transactions which minimally cost $13, you can see the benefit of using the Lightning Network.

There are two types of fees on the Lightning Network: a base fee and a liquidity provider fee.

Fees spelled in letter wood blocks with pile of gold coins on top

The base fee is a flat rate that is charged for transactions that are routed through the lightning node. As an example, if you’re operating on the network, you can charge 200 satoshis, which would cost around 1 cent for parties who want to route payments through your l-node. If you want to route multiple payments you can lower your fee to 100 satoshis, or even 1 satoshi. This fee is placed by the node operator on the network and is based on the worth of their capital.

If you’re providing services on the network, the liquidity provider fee is a fee that is based on how much liquidity a party is using in your channel. This fee could be charged for every satoshi that goes through your Lightning Network channel. For example, let’s say the fee is 0.02 satoshis for every satoshi that is sent through the channel. If the payment is 1,000 satoshis, the fee would be 20 satoshis. In simple words, these 20 satoshis would be the liquidity provider fee.

Pros of the Lightning Network

Let’s take a look at some of the main perks of using the Lightning Network:

  • Drastically greater transaction speed. Bitcoin’s scalability problems will no longer hold back the potential. The Lightning Network should take the transaction speed for Bitcoin and other cryptocurrencies like Ethereum, Litecoin, etc, to 1 million transactions per second. When you compare it to the current Bitcoin transaction speed of the humble 7 per second, lightning transactions look like a lost episode of Star-Trek.
  • No confirmation wait time. Once the network goes live, users won’t have to wait for several transaction confirmations for every transaction you make. This will happen instantly, regardless of how busy the network is. If it proves to be successful, the crypto market will reach a new level of power and it will be able to compete with every traditional payment method.
  • Drastically lower fees. The transactions will transpire in the Lightning Network’s channels and off the main blockchain. That means that the fees will be minimal or almost nonexistent. This will make Bitcoin a usable method of payment for everyday use in restaurants, shops, cafes, etc.
  • Cross-chain atomic swaps. The initial tests for cross-chain transactions proved very operational. As long as the different blockchains share the same cryptographic hash functions as most of the crucial ones do, users will be able to send assets from one chain to another without the need for third-party interference like crypto exchanges.
  • Security and anonymity won’t be an issue. The majority of cryptocurrencies are not as anonymous as one would like them to be. The transactions could be traced among the wallets, but with the Lightning Network most of the transactions are happening outside of the main blockchain, and thus they are almost impossible to trace. 

Cons of the Lightning Network

Now let’s take a moment to focus on the downsides of this technology:

  • It’s still in development. There is no way to determine how good the Lightning Network is going to be until it reaches a Beta stage of development. The concept looks revolutionizing on paper, but we’ll have to wait a bit more for a full realization.
  • The complexity of the lightning channels might be an issue. The Lightning Network’s concept is visualized as a mesh of channels. When these channels are established, in theory, they should allow effortless transactions among parties. For now, there is no oversight in what would happen if a transaction takes a longer route among various channels and ends up stacking some fees without any valid reason.
  • Hubs might start to appear. There have been some concerns about the forming of hubs. These hubs would look like nodes with lots of capital that the majority of transactions would go through. Some view this as further centralization of cryptocurrencies, but it seems unlikely that if these corporate-like hubs appear, that they will be able to amass great profits from transactions.

It’s very important to take these pros and cons with a grain of salt due to them being only speculative information since the Lightning Network has not yet been put to the test.

A Few Words Before You Go…

If you are a Bitcoin supporter and you’d like to use crypto for everyday payment, the Lightning Network might be the answer to your crypto-prayers. The promises of instant payments, cheap transaction fees, and almost guaranteed anonymity might sound like the promised crypto-land, but for now, things are still calmly brewing in the crypto-cauldron. 

This article aimed to give you a better understanding of this brand new Bitcoin ecosystem, and in some ways to bring you a trailer for the upcoming block(chain)buster that should be the Lightning Network.