Learn everything there is to know about the Bitcoin Lightning Network - including its development, use cases, and drawbacks!
The Lightning Network is a Layer-2 solution for the Bitcoin blockchain that was designed to tackle the issue of scalability for the purpose of facilitating micropayments. If you recall from our article about dApps and smart contracts - a Layer-2 solution sits on top of the main blockchain (Layer 1) and acts as an auxiliary blockchain - giving additional capabilities to the main blockchain and taking some of the processing load off. Layer-2 solutions are commonly referred to as "sidechains" or "off-chain" solutions.
In this case, the Lightning Network is actually an off-chain solution - which means that some of the data and code used sits outside of the blockchain. This presents added vulnerability due to external influences, but we'll discuss this more later.
Why was Lightning Network created?
The Lightning Network was proposed as early as 2015 by two researchers, Thaddeus Dryja and Joseph Poon. The duo was interested in creating payment channels on the blockchain that could rival Visa's transaction capacity, which was roughly 47,000 transactions per second (TPS) in peak holiday season. At the time, Bitcoin could only handle 7 TPS assuming that each transaction was 300 bytes - and the block size was limited to 1MB. Reaching Visa's TPS would be mathematically impossible if piecemeal block verification on the Layer-1 blockchain was required - and this was what later spurred Lightning Network to become a hybrid off-chain solution.
By 2016, Dryja and Poon started Lightning Labs with a handful of other developers. The first beta version came out in 2018, and today - the Lightning Network is capable of reaching speeds of up to 1 million TPS.
How does the Lightning Network work?
Here's a quick walkthrough to simplify the steps used in a transaction on the Lightning Network:
- First, the user must sign up for a Lightning Network wallet which will allow them to transact in Bitcoin using the protocol. These wallets can either be custodial (managed by a software provider or entity) or self-managed (private keys owned by you).
- Next, they must deposit a desired amount of Bitcoin into the wallet (acts as your total balance) and open a channel with another user or point-of-sale (POS) system. A channel can basically be thought of as a line of credit that stays open indefinitely until you close it. You can send Bitcoin to that individual in very small increments such as a Milli-Bitcoin, Bits, and Satoshis. And, it is only when you close it that all those combined micro-transactions are processed to the Layer-1 blockchain together.
- Why is this so important? If every transaction you made had to clear immediately on the Bitcoin blockchain, verifying and receiving the payment could take up to hours - and you would be charged extremely high fees to process even the smallest transaction. Imagine if paying for your cup of coffee took an hour, and you got slapped with a fee that is half the price to boot!
- Bypassing the immediate need to validate transactions on the Bitcoin blockchain while still enjoying privacy, security, and reduced fees is what makes the Lightning Network so powerful.
What are some popular Lightning wallets?
Blue Wallet is one of the most popular Lightning wallets, as it has the ability to be set to both custodial and non-custodial modes. It comes with an array of interesting (and sometimes controversial) features, including cold-storage management, multisignature vaults, transaction controls, and "Plausible Deniability" - which allows the user to create fake storages in the event of a forced disclosure.
Wallet of Satoshi is another crowd favorite, boasting itself as "the world's simplest Lightning wallet." This custodial wallet comes with no frills, other than the ability to scan QR codes and transact.
Electrum is the most popular non-custodial wallet, as it has been around since 2011. One of the highlights of Electrum are its security features and ability to facilitate both hot and cold storage of Bitcoin.
What are some of the weaknesses of the Lightning Network?
The single biggest glaring weakness of the Lightning Network is that some of the data is stored off-chain, making it more susceptible to hacks and external influence. Offline transaction scams can occur if a user decides to prematurely close a channel while the other user is offline - making away with the funds.
There are also occasional bugs in the protocol that may cause funds to get stuck in transit. This will not cause any loss of funds, as these transactions will be verified and corrected by the Layer-1 blockchain when reconnected - but the refund process is time-consuming and can take days.
Finally, one might argue that the Lightning Network is theoretically sound - but practically flawed. In order for your Bitcoin to be sent back to your wallet where it can be withdrawn or exchanged for fiat money, the channel must be closed first. So, even though you could leave the channel open for regular visits to your local Starbucks - this probably wouldn't work well if you were hoping to stop by a place just once. The result is that you would end up paying fees every time you closed a channel (which would be frequently) - defeating the purpose of lumping those micro-transactions together.
The Lightning Network is a great solution for those who are looking to fully-embrace Bitcoin payments with greater speed, privacy, and ease. In the near future, we may witness more upgrades that will help overcome the disconnect between Layer-1 and Layer-2 that prevents it from being practically used all the time.
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This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. Charts, graphs and references to any digital assets are for informational and illustrative purposes only.