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What is the Bitcoin Lightning Network?

Satoshi Nakamoto designed Bitcoin because he envisioned a peer-to-peer network where participants could exchange assets freely without any intermediary control. The first recorded purchase of a physical good using Bitcoin was on May 22nd, 2010, when Laszlo Hanyecz spent 10,000 Bitcoins at a local pizza restaurant called Papa John’s to buy himself two pizzas. In the world of crypto, May 22nd is now commemorated as Bitcoin Pizza Day. Conveniently, Laszlo once again purchased two pizzas in BTC, when the Lightning Network was completed in February 2018.

Bitcoin scalability issues

The idea behind Bitcoin started getting traction in the following years, but it soon became obvious that Bitcoin’s main issue lies in its scalability or in other words the speed at which it processes transactions. The industry standard is set by Visa, which processes over 1,700 transactions per second and can scale up to 24,000 TPS when transaction peaks occur. As Bitcoin can only process up to 7 TPS it is clear that its current form is unsuitable for large-scale adoption.

Bitcoin scalability issues lie in its block size and block time, so naturally, developers tried to solve the issue by up-scaling one or both of these parameters. Bitcoin was forked multiple times while trying to find the solution, but all efforts led to lower network security. It was clear that Satoshi had his reasons to design the Bitcoin block structure as it is.

After numerous fork attempts, the only viable solution left was to somehow process BTC transactions off-chain at a faster speed, while maintaining the necessary level of security and minimizing transaction costs. Fast forward to 2015, two long-time Bitcoin developers Thaddeus Dryja and Joseph Poon published a paper titled “The Bitcoin Lightning Network.”

The Lightning Network solution

The Lightning Network is designed as a Layer 2 solution developed on top of the Bitcoin chain. However, unlike other Layer 2 solutions, the Lightning Network is not a blockchain. It is structured as a set of off-chain payment channels called multi-signature wallets which are used by individuals.

Transactions done through the multi-signature wallet only get written on the blockchain when their specific payment channel gets opened and closed. Between the two events, multi-signature wallet participants can carry out as many transactions as they wish without having to pay for high Bitcoin transactions and wait 10 minutes for their transaction to get processed.

Imagine you are a regular customer at a local bar and the business owner agrees to open a tab for you. Now you can order as many drinks as you like and only pay for them at the end of the night. This serves as the perfect analogy for the Lightning Network.

Now, let’s say that the bar owner and you decide to cover the costs of your drinks in BTC. You can open a new payment channel in the form of a multi-signature wallet — the name already suggests that you both have equal access to it — and you both deposit a certain amount of crypto assets to it. Each time a transaction is made between you two, crypto assets in the multi-signature wallet get redistributed between you accordingly. Since all of these transactions happen off-chain, they aren’t limited by the size and speed of Bitcoin block mining and charge you near-zero fees. The speed is subject only to the user’s computer power and internet speed which in theory makes the Lightning network capable of processing millions of transactions per second.

The Lightning Network payment channels require only two on-chain transactions — the initial one when a payment channel gets opened and the final one once one of the multi-signature wallet users decides to settle the costs. An individual payment channel can remain open indefinitely and it can be finalized at any time by any of its participants. Once a finalization request is made, the multi-signature wallet publishes its last asset distribution record on the blockchain and pays out all of its participants accordingly. In the case where one of the participants doesn’t want to pay, the deposited collateral is used to cover the relevant cost.

Global payment network

To achieve a large-scale adoption the Lightning Network developers made payment channels interconnected. This means that you don’t need to open separate payment channels with every store you visit. You can actually benefit from payment channels opened by other network participants and use their channels in exchange for a small financial incentive.

For example, if your friend takes you to their favorite restaurant, who they have a channel with, Lightning Network would allow you to route your payment through your friend when you pay for a meal, without you needing to open a new channel with the restaurant. Lightning nodes make sure to always find the best and fastest route to perform the transaction.

These intermediary pathways are additionally secured by a specific form of smart contracts called hashed timelocks which ensure that intermediaries used in your payment route cannot take advantage of your assets.

The Lightning future

The Lightning Network offers developers the chance to set up their own custom versions of the network which are all interoperable, thus fulfilling the vision of a global peer-to-peer payment network. In addition, the network can be used with any cryptocurrency that supports multi-signature wallets and hashed timelock contracts. At almost no cost, people all over the world can now use crypto payments bypassing all central authorities.

However, such revolutionary solutions never roll out without initial struggles. Until today, the Lightning Network had to tackle numerous code vulnerabilities and structural issues. Another factor that can heavily influence its payment channels is Bitcoin’s volatility and the lack of incentives to keep channels open for longer periods of time.

The network’s characteristics could also be seen as somewhat problematic from the regulator’s point of view because the security level of lightning transactions makes those transactions hard to track.

In any case, the network has been growing exponentially, showcasing a 400% increase in payment volume between the first quarter of 2021 and the first quarter of 2022. In March 2022, It was estimated that more than 80 million people had access to Lightning payments on an installed application.

It looks like the payment channel solution that Satoshi envisioned even before Thaddeus Dryja and Joseph Poon is finally becoming a reality. And it is laying the foundation for an unprecedented shift in the way we pay for our products and services. In the future, we might start paying for streamlining services by the minute instead of monthly subscriptions. By avoiding costly transaction fees, there will be no other reason to avoid instant compensation. Not instant — lightning fast.

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