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The Bitcoin blockchain can only process 7 transactions per second on average. This is insufficient to establish Bitcoin as a viable platform for processing the millions of transactions generated every day. As a result, if Bitcoin is to become a medium of exchange, payment mechanisms that allow users to transact bitcoin rapidly and cheaply must be implemented. One such payment mechanism is the Lightning Network.
The Lightning Network is a second layer added to Bitcoin’s (BTC) blockchain that permits off-chain transfers or transactions between parties that are not connected to the blockchain network. The second layer is made up of several payment channels between parties or Bitcoin users. A Lightning Network channel is a two-party transaction technique that allows parties to send and receive payments from one another. Layer two improves the scalability of blockchain applications by handling transactions outside the blockchain mainnet (layer one) while retaining the mainnet’s robust decentralized security paradigm.
The issue of scalability is a significant roadblock to the wide-scale adoption of cryptocurrencies. When appropriately scaled, a blockchain network is capable of processing millions to billions of transactions per second (TPS). In this regard, the Lightning Network charges low fees by transacting and settling off-chain, enabling new use cases like rapid micropayments that solve the classic “can you buy coffee with crypto” dilemma by shortening processing times and lowering related costs (energy costs).
A brief history of the Lighting network
Two academics, Thaddeus Dryja and Joseph Poon proposed the Lightning Network in 2015 in a paper titled “The Bitcoin Lightning Network.” Their writings were inspired by Satoshi Nakamoto’s preliminary talks about payment methods. Nakamoto discussed payment methods with fellow engineer Mike Hearn, who transcribed the talks and released them in 2013.
Dryja and Poon (together with a few other collaborators) launched Lightning Labs in 2016, a firm committed to developing the Lightning Network. Lightning Labs strived to ensure that the protocol was compatible with the Bitcoin core network.
Lightning Labs deployed a beta version of their Lightning Network implementation into the Bitcoin mainnet in 2018. At this point, prominent figures such as Twitter creator Jack Dorsey became involved in the initiative. For example, Dorsey compensated a group of developers in Bitcoin to work entirely on Lightning Network development. Additionally, he intends to incorporate the Lightning Network into Twitter in the future.
How does the lightning network work?
The lightning network proposed a solution to the scaling issue by adding a second layer to bitcoin’s main blockchain. That second layer is made up of several payment channels between parties or bitcoin users. A lightning network channel is a two-way transaction mechanism. The parties can make or receive payments from each other via channels.
These transactions are handled differently from regular transactions on the bitcoin blockchain. When two parties open and end a channel, they are only updated on the main blockchain.
Between those two acts, the participants can transfer cash indefinitely without alerting the main blockchain of their activity. This method significantly increases the speed of a transaction.
For example, assume Priya creates a channel with her favourite coffee shop and deposits INR 1000 in bitcoin. Because she has a direct line to the coffee shop, her transactions with it are instant.
Rahul, who has another channel open with his favourite grocery store, also buys coffee from Priya’s shop. The link between Priya, the coffee shop, and Rahul guarantees that Priya may utilize her coffee shop balance funds to buy food from Rahul’s store. Similarly, Rahul may utilize his grocery shop balance to execute purchases with Priya’s network.
If Rahul shuts his channel with the grocery store (assuming there are no other customers in common between the coffee shop and the grocery store), Priya will need to create a new channel with the grocery store in order to make purchases there. In this approach, a decentralized web of transactions is established and transmitted through many lightning nodes.
On a more technical level, the lightning network implements this goal using smart contracts and multi-signature scripts. When one or both parties fund a channel, a first transaction, known as the funding transaction, is formed. Two master keys (one public and one private) are first exchanged in a typical multi-signature scenario. The exchange makes it easier to get and spend money.
However, in the event of a lightning node, the signatures are not transferred. This is done to avoid the spending of the financing transactions from being recognized by the main blockchain. Instead, the two parties exchange a single key, which is then used to validate spending transactions (also known as commitment transactions) between them.
The two parties can perform an infinite number of commitment transactions with other nodes on a lightning network. They only exchange master keys when the channel between them is closed.
What are the fees for lightning network transactions?
The use of the lightning network does incur transaction fees. They are a mix of routing costs for transferring payment information between lightning nodes and bitcoin transaction fees for opening and closing channels. However, these fees are minimal in comparison to the traditional bitcoin network transfers, costing a few rupees.
What are the drawbacks of the lighting network?
The most obvious issue with lightning networks, which are intended to be decentralized, is that they may duplicate the hub-and-spoke architecture that defines today’s financial institutions. In the current model, banks and financial institutions serve as the primary mediators for all transactions.
Lightning nodes for prominent businesses may become equivalent hubs or concentrated nodes in the network by having more open connections with others. A failure at one of these hubs may quickly bring down a large section (or the whole) network.
Another important issue, as previously noted, is the need to increase fees in order to keep the network financially sustainable. This is true not only for the nodes that run the lightning network but also for the potential cost of higher bitcoin fees that are transferred to the network.
Because lightning networks must remain active at all times, they are thought to be vulnerable to hackers and robberies. As a result, cold storage of coins is not a possibility since the network forbids it.
Like all other innovations within the blockchain space, the Lightning Network is a constantly developing concept that has the potential to revolutionize Bitcoin’s blockchain significantly. However, the network may not be the answer to all of Bitcoin’s problems. Furthermore, when new modifications and enhancements are introduced to the network, new problems within the cryptocurrency’s ecosystem may arise. In the future, much will be dependent on the research and development of new technologies.Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.