With the potential to solve Bitcoin’s scalability problems and help push its adoption as an acceptable form of payment both online and in person, the Lightning Network has Bitcoin supporters understandably excited. But just what is the Lightning Network and how does it work?
Why is the Lightning Network Needed?
Scalability is the name of the game when it comes to blockchain technology. This is especially true of Bitcoin if it wants to be seriously considered as a medium of exchange for the general public. This is because Bitcoin has one of the slowest transaction speeds at just 7 transactions per second, whereas Visa does 1700 per second. So if you want your transaction to be done quickly with Bitcoin you end up paying exorbitant fees.
For example, at the peak of Bitcoin you could easily be paying $50 USD in fees to have your transaction included in the next block. If you were trying to use Bitcoin to buy a cup of coffee and were required to pay instantly to receive your coffee, which is the case, theoretically you’d be paying over $50 for that coffee in order to avoid standing in the coffee shop for a few days waiting for the transaction to be completed. As more and more people will want to use Bitcoin for microtransactions like buying that cup of coffee, a solution is needed. This is where the Lightning Network comes in.
What is the Lightning Network?
The Lightning Network is a layer on top of the Bitcoin blockchain where users can create channels between two or more parties. Transactions between these parties are nearly instant because they do not take place on the public blockchain. The Lightning Network in theory can solve Bitcoin’s scalability issues by allowing millions of transactions per second on the network, therefore allowing things such as microtransactions to be feasible.
How Does It Work?
Users open payment channels on the Lightning Network. These channels are bidirectional meaning that payments can be sent either way, allowing for things such as refunds. Once the channel is open and funded the parties involved can perform a theoretically infinite number of transactions at instantaneous speeds with fractional fees per transaction.
At this point the only transaction that takes place on the main Bitcoin blockchain is your funding of the channel, called the “funding transaction”. The channel should be thought of like a tab at a bar, the initial funding is the equivalent of handing over your credit card (there is a funding limit that will be discussed later), and your tab is settled, as in you actually pay, when you close the channel and this is the only other transaction that takes place on the main Bitcoin blockchain.
If we take the idea of buying a cup of coffee again, you as the consumer opens a channel with the coffee shop using their public address on the Lightning Network and fund your end of the channel. You can then pay for the coffee instantly with almost no fee. If your friend also opens a channel with the coffee shop you can now not only send the coffee shop Bitcoin, but also your friend, as it will simply route through the coffee shop to him as they are both part of the network. You could purchase multiple cups of coffee and pay your friend back for something and because none of this takes place on the main blockchain it is nearly instant. It is when you close the channel that the final balances of all parties involved are recorded on the main block.
Theoretically then, the goal of the Lightning Network is to have so many open channels between so many parties that it is possible to pay any merchant or party you desire without needing to open a new channel with them directly. Transactions would then be nearly instantaneous across the network.
Limitations and Potential Problems
While the Lightning Network theoretically solves many of the issues Bitcoin faces as a usable medium of exchange it does have a few limits and creates a few problems.
The first limitation is that you have to be connected to the internet to either complete a transaction or to route payments, meaning that if you or the coffee shop lose connection the transactions will not occur. This also means if the coffee shop has no internet and you try to send money to your friend who is connected to them as well, that transaction will fail as well.
The next two limitations are tied together in the form of funding limits and refills for channels. Currently, due to the young nature of the Lighting Network and for security, you can only fund a channel with approximately $150 USD max for each party, meaning channels have a value limit of about $300 total. In addition, once you open that channel you cannot add more funds or “refill” it, meaning even if you only put $100 worth of Bitcoin in there, you cannot add $50 more later, or $150 if you spend it all, but instead have to open another channel. The funds in the channel are also locked into it, so until it is closed you cannot use those funds elsewhere.
It should be noted that the Lightning Network does not have the same security as the Bitcoin blockchain, meaning that high dollar transactions will likely not be suited for it unless that changes.
Finally, the crime potential of the Lightning Network should be noted as well, as it is an area of major concern for centralized governments, banks, and regulatory agencies. Despite the fact that there is a relatively low dollar limit placed on individual channels, anyone anywhere can make a channel anonymously, and with VPNs traceability becomes nearly impossible. This means criminal activity such as money laundering, terrorist financing, or human trafficking is easily conceivable. These types of organizations already use microtransactions to execute most of their crimes, so being able to make them more anonymous and faster through the Lightning Network is a definite possibility.