Bitcoin Lightning Network: How does it work?

10 days ago

Bitcoin Lightning Network: How does it work?

The Bitcoin lightning network is one of the most important inventions since Bitcoin was introduced. Bitcoin transactions are all tied to the blockchain and therefore are referred as on-chain transactions. This groundbreaking technology makes Bitcoin not only a censorship resistant network, but it ensures also that Bitcoin is hard money. It cannot be counterfeited and it cannot be confiscated. This system is rock solid but it comes also with a downside.

On average, every 10 minutes a new block is found. Therefore, the transaction throughput is very limited and it takes a very long time to confirm a transaction on-chain. If you compare this for instance to a credit card payment it is awfully slow. But this is not a bug, it is a feature. Bitcoin sacrifices speed to ensure maximum security and decentralization of the network. This is also known as the blockchain trilemma, you can always only get two features of the three that we mentioned.

Over the last 5 years or so many projects have stepped up and tried to solve the trilemma, but so far nobody could prove that claim. Bitcoin is using the lightning network not to tackle the trilemma, but to solve scalability as an issue with a workaround.

But what is the lightning network? And how does it work? In today article we are about to explore Bitcoins very own second layer solution.

Second layer technology

A layer 2 technology generally refers to a technology that is build on top of an already existing blockchain. Bitcoin is not the only cryptocurrency that is exploring the use of this technology. The protocol of a second layer technology is meant to solve the scalability issue as we have described it before.

It enables transactions that are not immediately processed as on-chain transaction and are instead verified by the second layer protocol. This makes transactions faster, but also more fragile, because both protocols have to ensure that every transaction is secure by communicating with each other. On-chain transactions are very reliable and cause no known issues what’s so ever. But the layer 2 transactions are complete independent and are therefore referred to as off-chain transactions.

Examples for layer 2 technologies are Bitcoin’s lightning network and Ethereum Plasma. Both try to solve the same problem, but for each blockchain. Other networks like Litecoin are also using their own implementation which also serves as a kind of testing ground for the new technology.

How does it work?

If you like to enter the lightning network, it requires you to communicate from the Bitcoin network. Therefore, it has its own wallets and its own nodes. The first step to take part in the lightning network is to send Bitcoin from a traditional Bitcoin wallet to your lightning wallet.

You now hold BTC that is off-chain. Let’s say you are at the central station and you would like to have a coffee before you get your train. Paying the coffee works through so-called payments channels that are opened by lightning nodes. You can transfer the payment for your coffee in an instant and don’t have to wait until the transaction is confirmed on-chain.

Instead, there is no on-chain transaction required. It is still possible to finalize off-chain transactions by closing a payment channel and settling its transaction on the Bitcoin blockchain. Lets say the store is closing and the owner like to settle the transactions on-chain, he then closes the channel for settlement. He now receives the BTC that he earned during the business day on his own regular wallet.

It is worth to mention that everything that is happening on the lightning network is not recorded on-chain. Only the finalization is settled.

Is the Lightning Network secure?

The lightning network is secure, but it still has a lot of hiccups. Meaning that it is not recommended to send large amounts of BTC through its payment channels. Ultimately the layer 2 solution is more attractive for immediate settlement of smaller transactions. But the fact that there are still existing bugs makes it still difficult to adopt the technology for stores.

Let’s say you would like to buy a TV for a 1000€. Nobody would risk losing that amount of money. What seems to be acceptable buying a coffee isn’t acceptable in other cases. But that doesn’t mean that the technology isn’t safe or generally poorly designed. It is worth to mention that Bitcoin had a lot of bugs in its early days and the lightning network is still in a very early phase.

The developers have found and closed a lot of vulnerabilities and bugs in the past. It is to be expected that the technology will improve further in the years to come. Most of the known vulnerabilities have never been exploited. So, the lightning network is generally speaking secure, but one is well advised to be cautious and not to transact large amount of money off-chain.

Are there any alternatives?

The lightning network requires two protocols and settlement that takes place off-chain. Many critics felt that this is highly unacceptable, because the gap between on-chain and off-chain transaction could create an additional attack surface. Furthermore, the lightning network isn’t in the same way transparent as the blockchain. One of the big advantages of blockchain technology is that everything can be verified by the network. Payment channels on the other hand are opened and closed, while the final settlement on the blockchain is not allowing to search the off-chain history.

In response to Bitcoins scalability issue, there has been a lot of struggle within the Bitcoin community. That led to alternatives but also to division. One possible option to increase the transaction throughput is to increase the block size. A bigger block can include more transactions. During the year 2017 there was a very fierce debate in the Bitcoin community that led to the hard fork that is known as Bitcoin Cash. Bitcoin Cash is trying to solve the problem by increasing the block size instead of opting for a layer 2 solution.

Bitcoins block size is not to be increased and instead another technology has been introduced to scale on-chain transactions. This technology is called segregated witness or in short SegWit. It allows to handle information separately from each block and in effect is saving space reducing the size of signatures. This allows to fit in more transactions in each block without increasing the block size.

The Lighting network will change Bitcoin

It is worth to mention that the idea of the lightning network is not new and was in fact mentioned very early by Satoshi Nakamoto himself as a possible solution. In conclusion, the lightning network will expand the possibilities and payment options for Bitcoin.

Many investors perceive Bitcoin as a speculative asset or a store of value. It was meant to be a payment system and the lightning network is the most promising solution to restore that vision and make Bitcoin payments more attractive. It remains to be seen if the Bitcoin community is going to succeed by strengthen the development and implementing the layer 2 technology wherever possible. Looking at the bigger picture mass adoption of Bitcoin payments is a requirement for a worldwide success of BTC.

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