What Is the Lightning Network and How Does It Help Bitcoin?

May 6, 2021

Even a decade after the blockchain industry’s emergence scalability remains to be the biggest issue. Cryptocurrencies like Bitcoin and Ethereum are now used more than ever, but they fail to keep up with the demand. 

If we want to replace giant payment networks like Visa, which processes 24,000 transactions per second (TPS), Bitcoin must overcome its minuscule transaction throughput of 7 TPS. 

The Bitcoin community has proposed many scalability solutions over the years, but none have grabbed the market’s curiosity as much as the Lightning Network: a revolutionary approach to lowering network congestion by targeting small payments. 

What is the Lightning Network?

The Lightning Network is a layer 2 scalability solution that processes Bitcoin transactions off-chain in order to make them faster and cheaper. By focusing on micro-payments and small transactions in general, the Lightning Network frees up space on the Bitcoin blockchain, thus helping with network congestion.

The solution is being developed since 2015 with the premise that not all transactions need to be recorded on the blockchain. This means that the community needs to abandon a couple of principles and security concerns in order to use Bitcoin like a credit card - which may not be that big of a deal in the end.

Lightning Network’s ultimate benefits are that Bitcoin will not only become more efficient but consume less energy as well, which is extremely important now that Bitcoin spends more power than entire countries.

To scale, the Lightning Network creates an additional layer on top of the Bitcoin blockchain where users can send and receive payments. Transactions made within this channel are processed differently compared to Bitcoin, and they are only updated on the ledger after both parties open and close a payment channel.

While the channel is open, users can transfer money without informing the Bitcoin blockchain, which in return dramatically increases transaction speeds as they are not forced to be confirmed by all nodes. A combination of multiple such channels forms an entire network where everyone interacts seamlessly with other Bitcoin holders in a way that is fast and inexpensive.

How the Lightning Network works

The Lightning Network uses a mix of smart contract technology and multi-signature wallets to function in the way that it does. It works by allowing users to deposit cryptocurrencies in a wallet where both sides have complete access via private keys. After a transaction has been issued, it has to be signed in order to create an updated balance sheet.

Coins are only distributed once the payment channel is closed, for which the lightning network uses the most recently updated balance sheet to figure out which users possess which coins.

After successfully transferring Bitcoin to everyone, the channel’s transaction history is then broadcasted to blockchain nodes in a single transaction. The ultimate result of such a structure is extremely beneficial for Bitcoin.

For example, let’s say that Bob and Alice trade hundreds of coins with each other in the period of one year. If they decide to stop trading or engage with another person, the channel will close and send a year’s worth of transaction data to the Bitcoin network in only one transaction. We can only imagine what of an impact LN would have even if it was adopted by only 10% of Bitcoin users. 

If even a tiny percentage of the crypto community utilized the Lightning Network, we would see a tremendous fall in network congestion. And since Bitcoin itself would become more effective, its value would drastically increase. 

The disadvantages of Lightning Network

The main problem with the Lightning Network stems from its solution: off-chain transactions.

Since transactions are not being carried out on Bitcoin but on another layer, users lose access to the cryptocurrency’s extremely good security. Because of this, the Lightning Network will have to limit itself to smaller transactions, and Bitcoin would primarily process larger transfers due to its decentralized security.

Another problem is that a low fee rate is not economically viable for Lightning Network nodes that support the system. Unless fees rise along with adoption rates, there will be no incentive for nodes to report back to the main Bitcoin blockchain. According to scientists from the Institute for Computer Science and Control in Hungary, fees would have to dramatically increase for Lightning Network to work. 

It is also worth noting that Lightning Network’s system could, in the end, replicate the same old financial model that we have today and that payment channels would act as centralized bottlenecks that can wreck the entire network if even a single one fails.

The advantages of Lightning Network

We have already mentioned a few advantages, but it would be worth it to pinpoint what the Lightning Network brings to the table.

First of all, the solution can reportedly decrease transaction fees to one satoshi. Given that fees now average at $20 per transaction but went as high as $60 in April, the Lightning Network would completely change the game for Bitcoin. 

Secondly, the network brings real-world use cases that are currently not possible. 

For example, buying a cup of coffee in Starbucks would take anywhere from 10 to 30 minutes due to Bitcoin’s slow transaction times. Considering that the Lightning network processes transactions almost instantly, Bitcoin users would be able to spend their coins just as fast as with a credit card.

Final Word

Despite rolling out slowly in the beginning, the Lightning Network’s growth is now skyrocketing. The number of active nodes has doubled every single year since 2018, and today the network counts a total of 10,839 nodes

In terms of real monetary value, we finally see critical progress. Lightning Network went from holding $8.5 million to $52 million in the span of a single year.

A number of major crypto exchanges have also decided to integrate the solution in the meantime, which includes OKEx, Kraken, and bitFinex

Even if the Lightning Network isn’t perfect, it still does a great job at alleviating Bitcoin no matter how small a percentage of the community utilizes it. If developers succeed in eliminating the layer 2 platform’s limitations, we could potentially see it becoming the primary tool for conducting small payments while large transfers of wealth are done on Bitcoin’s first layer. 

Once security issues are out of the way, the Lightning Network can at least turn Bitcoin into the currency of the internet by providing it a serious spot in micropayments. It is believed that the network can thrive in the gaming industry and other sectors where small but secure payments are needed instantly.
In the case that Bitcoin fails as a currency, it will still represent a great speculative asset and store of value. For payments, we might as well use Ethereum 2.0 after we see a complete implementation of proof of stake.

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