Cryptocurrency

Lightning Network

What is Lightning Network?

The Lightning Network is a second-layer technology applied to Bitcoin that uses micropayment channels to extend the capabilities of its blockchain to conduct transactions more efficiently. Transactions made on the Lightning Network are faster, less expensive, and easier to confirm than transactions made directly on the Bitcoin blockchain (i.e., on-chain).

By taking transactions off the main blockchain and taking them off-chain, the Lightning Network aims to de-congestion the Bitcoin blockchain and reduce the associated transaction fees. The Lightning Network can also be used to conduct other types of off-chain transactions involving transactions between cryptocurrencies.

For example, it helps facilitate atomic swaps, where one cryptocurrency can be exchanged for another without the involvement of an intermediary, such as a cryptocurrency exchange.

key takeaways

  • The Lightning Network is a technical solution designed to solve the transaction speed problem on the Bitcoin blockchain by introducing off-ledger transactions.
  • Much like blockchain, the Lightning Network disconnects central institutions such as banks, which are responsible for routing most transactions today.
  • The Lightning Network was originally formalized in a 2015 paper by Joseph Poon and Thaddeus Dryja.

Learn about the Lightning Network

The Lightning Network was first proposed in 2015 by Joseph Poon and Thaddeus Dryja and has been in development since then. The problem that the Lighting Network is designed to solve is Bitcoin’s slow transaction times and throughput.

To realize its potential as an everyday medium of exchange, Bitcoin needs to reach tens or hundreds of thousands of transactions per second, similar to a credit card or electronic payment network. Bitcoin in its current state is riddled with such issues due to the nature of its decentralized technology requiring consensus of all nodes within its network.

For example, if the number of transactions on the Bitcoin network were to multiply, it would become expensive and time-consuming to approve and store transactions. The increase in the number of transactions will also require an order of magnitude increase in the processing power of the computers required to execute transactions involving Bitcoin. Additionally, the energy required to compute this information is enormous, making it prohibitively expensive to maintain Bitcoin for day-to-day transactions.

The Lightning Network proposes to solve the scaling problem by creating a second layer on top of Bitcoin’s main blockchain. The second layer consists of multiple payment channels between parties or Bitcoin users. A Lightning Network channel is a transaction mechanism between two parties. Using channels, parties can pay each other or receive payments.

These transactions are handled differently compared to standard transactions that occur on the Bitcoin blockchain. They are only updated on the main blockchain when two parties open and close the channel.

Between these two actions, parties can endlessly transfer funds between themselves without notifying the main blockchain of their activity. This approach greatly speeds up transactions, as all transactions do not need to be approved by all nodes within the blockchain. Individual payment channels between parties combine to form a network of Lightning nodes that can route transactions between them. The interconnection between various payment channels leads to the Lightning Network.

How Lightning Network Works

Suppose Alice opens a channel at her favorite coffee shop and deposits $100 worth of bitcoins in it. Her transactions with the coffee shop are instant because she has direct access.

Bob starts another channel at his most frequented grocery store, and he also buys coffee from Alice’s store. The connection between Alice, the coffee shop, and Bob ensures that Alice can use the funds in her balance at the coffee shop to buy groceries from Bob’s shop. Likewise, Bob can use his grocery store balance to transact with businesses in Alice’s network.

If Bob closes his channel with the grocery store (and there are no other mutual customers between the coffee shop and the grocery store), Alice will have to open another channel with the grocery store to be able to shop there. In this way, the transaction network is created and routed among multiple Lightning nodes in a decentralized manner.

On a more technical level, the Lightning Network uses smart contracts and multi-signature scripts to achieve its vision. When one or both parties fund a channel, an initial transaction called a funding transaction is created. In a typical multi-signature environment, two master keys (one public key, the other private key) are initially exchanged. Exchanges facilitate the acquisition and disbursement of funds.

However, in the case of Lightning nodes, the signatures are not exchanged. This is done to prevent the spending of a funding transaction from being recognized by the main blockchain. Instead, the two parties exchange a key that is used to verify the spending transaction (also known as a commitment transaction) between them.

Two parties can trade endless commitments between themselves and other nodes on the Lightning Network. They exchange master keys only when the channel between them is closed.

Is there a fee to use the Lightning Network?

Yes, there are transaction fees for using the Lightning Network. They are a combination of routing fees for routing payment information between Lightning nodes and transaction fees for opening and closing channels in Bitcoin.

In November 2019, scientists from two Hungarian universities and the Institute of Computer Science and Control published a Paper This questions the ability of Lightning Network operators to continue processing transactions without significantly increasing fees. In their abstract, the authors say, “Participation is not economically justified by most of the large routing nodes currently linking networks together. Traffic or transaction fees would have to increase by orders of magnitude to make payment routing economically viable. feasible.”

What’s wrong with Lightning Network?

Lightning Networks are inherently decentralized, and the most obvious problem is that they could lead to replicating the hub-and-spoke model of today’s financial system. In the current model, banks and financial institutions are the primary intermediaries through which all transactions take place.

By establishing more open connections with others, the Lightning nodes of well-known businesses may become similar hubs or centralized nodes in the network. The failure of one such hub could easily bring down most (or the entire) network.

Another important issue mentioned earlier is that costs must be added to make maintaining the network economically viable. This applies not only to the nodes maintaining the Lightning Network itself, but also to on-chain costs that translate into potentially higher Bitcoin fees for the network.

Lightning Networks are also considered vulnerable to hacking and theft because they need to be always online. Therefore, cold storage of coins is not an option, as the network does not allow it.

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