What Is The Lightning Network (Bitcoin)? Definition, How It Works

What Is Lightning Network?

Lightning Network is a cryptocurrency protocol that works with distributed ledger technology. Created by Joseph Poon and Thaddeus Dryjain, it is a layer two (L2) scaling solution for the Bitcoin blockchain.

Why Is Lightning Network Important to Bitcoin?

Bitcoin’s transactions are not fast enough to challenge global payment networks like Mastercard and Visa, and its transaction fees are not cheap enough to be competitive.

According to blockchain analytics firm Arcane Research, Bitcoin’s practical transaction capacity is only seven transactions per second (TPS) compared to Visa’s TPS of 5,200 (as measured in 2021).

If you’ve ever transferred BTC from a crypto exchange to your crypto wallet you will notice that the transaction confirmation can take as long as 10 minutes or even more. Now imagine spending an extra 10 minutes in your Uber or in a cafe waiting for payment confirmation. Bitcoin payments need instant confirmation for practical everyday use.

Additionally, Bitcoin transaction fees are quite high for a payment network that wants to be used for big and small purchases. On-chain data compiled by Blockchair on 11 July 2023, showed that a Bitcoin transaction cost an average fee of $1.12.

These are the reasons why Joseph Poon and Thaddeus Dryja proposed the Lightning Network in a whitepaper published on 14 January 2016.

The whitepaper proposed a network of bidirectional payment channels built on top of the Bitcoin blockchain to enable faster and cheaper transactions without compromising the security and decentralisation of the payment system.

How Does the Lighting Network Work?

According to the Lightning Network’s whitepaper, the theory behind the scaling solution is to publish “the bare minimum of information” on the Bitcoin blockchain and to add the net settlement to the blockchain later.

Lightning Network uses multi-signature transactions and smart contracts to create a payment channel between two parties. Consent from both parties is required to process a money transfer.

To create a Lighting Network channel, parties create a ledger by placing funds into a two-party multi-signature Bitcoin address. Payments made on the channel are instant and cost zero-gas fees as the transactions are conducted off-chain and are not published on the Bitcoin blockchain.

Gas fees are paid only when interacting with the Bitcoin blockchain, which occurs typically when creating/closing the channel and adding funds to the channel.

The channel can be closed at any time by either party by broadcasting the state of the channel to the underlying blockchain.

In this system, the Bitcoin blockchain plays the role of the arbiter. Transactions that are made off-chain (Lightning Network) with the confidence of on-chain enforceability.

Lightning Network Explained: A Use Case Example

To get started, an initial channel funding transaction must be created where one or both parties add bitcoins to the channel.

For example, John and Mary want to create a Lightning Network channel and fund their channel with 1 BTC by contributing 0.5 BTC each. Each party will have output balances of 0.5 BTC each. Both John and Mary will need to sign off on any spending of funds.

When John goes to Mary’s shop to buy goods worth 0.1 BTC, he can initiate a transaction to transfer 0.1 BTC to Mary. Mary, with an updated channel balance of 0.6 BTC, can transfer John 0.3 BTC for his vehicle repair services. The parties will not have to pay Bitcoin transaction fees for the two above-mentioned transactions as the payments are taking place on the Lightning Network channel and not directly on the Bitcoin blockchain.

John and Mary will only pay Bitcoin gas fees to open and close the channel. They will however have to pay a minimal routing fee to Lightning Network nodes.

If Mary wishes to close the Lightning Network channel with John and withdraw her Bitcoins, she can do so without John’s consent. The latest channel balance that the parties agreed upon will remain valid.

How Can Everyday Crypto Participants Use Lightning Network?

Recent years have seen numerous Lightning Network integration announcements from cryptocurrency exchanges, digital wallets, and other crypto-friendly companies allowing everyday users to send Bitcoin over the Lightning Network without a fuss.

Twitter allows users to send and receive tips in Bitcoin facilitated by a Lightning Network-integrated Bitcoin wallet called Strike. The micro-blogging site is not the only platform that uses the Lightning Network technology with newsletter platform Substack among the first to allow bitcoin payments using the Lightning Network.

Central American nation El Salvador is a major Bitcoin and Lightning Network hub with cafes, restaurants, hotels and other businesses introducing Lightning-based payments to facilitate seamless crypto payments.

As a result, the number of payments on the Lightning Network roughly doubled in April 2022 (compared to the previous year) as commerce payments and personal transfers increased.

Disadvantages of the Lightning Network

The scaling solution has been around for several years now and it has divided opinion among Bitcoiners.

Here are some criticisms about Bitcoin’s Lightning Network:

Liquidity limitations: It requires users to first deposit a balance to channels which creates liquidity limitations in the system.
Routing fees: It does not entirely remove transaction fees for its users. Parties have to pay gas fees to open and close payment channels. Users also have to pay routing fees to Lightning Network nodes to process payments.
Imbalance in channel: Single-direction payments can lead to an imbalance in channel funds which will result in bitcoins being stuck on one side of a channel.
Inbound illiquidity: Users may only be able to send bitcoins (and not receive) if all the funds are sitting on their side of the channel. This event is known as inbound illiquidity.
Liquidity bottlenecks: Large Bitcoin payments may not go through on the Lightning Network if there is not enough liquidity in the channels.
Nodes operations: Users operating their own nodes need to have their systems up 24/7 in order to sign off transactions. Although they can use the Lightning Network without running their own nodes, this is considered the most secure and private way to use it.

The Bottom Line

Bitcoin’s low scalability has resulted in the cryptocurrency being branded as a ‘store of value’ rather than a global payment system. Innovations such as the Lightning Network are working towards changing this narrative.

The Lighting Network continues to innovate and empower the Bitcoin network by enabling stablecoins and cross-chain capabilities.