In this episode of our BeInCrypto News Show, Juliette Lima explains how the popular Bitcoin Lightning Network works.
As the use of the Bitcoin network has increased, transaction times and costs have also increased. At just 7 transactions per second, the BTC network is currently unable to process a large number of payments. The reason is that all bitcoin transactions are transmitted from every node in the network. Once this has happened, transactions still need to be performed on the blockchain.
A new block is created every 10 minutes, with which a number of operations can be processed. However, since the number of transactions for a block is limited, the fees rise sharply as network participants pay higher prices for faster processing.
The Bitcoin Lightning Network
This is where the Lightning Network comes in. Developed in 2015 by Joseph Poon and Thaddeus Dryja, the Lightning Network is a second layer protocol stacked on top of the Bitcoin network. Its inventors used the concept of payment channels to address Bitcoin’s scalability issues and optimize the speed of on-chain Bitcoin transactions and cost per transaction.
If you’re not familiar with the term “second layer protocols”, here’s an analogy.
Think of gold as an entry-level form of currency. Although it has several valuable properties, such as rarity, durability, and fungibility, its weight makes it undurable. In the past, one solution was to use paper receipts, which effectively represented a certain amount of gold that could be safely stored.
People thought they could take this paper to the bank and exchange it for gold. Eventually, these paper invoices turned into currencies. The convenience of paper slips made transactions easier and they could be done much more frequently.
One could think of fiat currencies as the second layer above the first layer of the gold standard. Bitcoin and the Lightning Network work similarly to gold and fiat currency.
In the case of Bitcoin, the choice was made to optimize security and decentralization to the detriment of transaction speed.
Ultimately, this also led to highly variable transaction fees, which depend on network requirements. These two points make on-chain bitcoin payments difficult, especially in small daily increments.
The Lightning Network efficiently offloads bitcoin and is instead optimized for high speed and low cost to eventually transact with bitcoin on the mainchain
Bitcoin payment channels – how the Bitcoin Lightning Network works
The Lightning Network works by establishing a payment channel between two separate parties, called a funding transaction. Both parties fund the chain with on-chain bitcoin, creating an on-chain deal between the two parties. These funds represent the maximum capacity of the channel, you cannot spend more than the sum of these funds together.
This financing operation, the first channel opened between two parties, uses what is called a multi-signature address. These require more than one signature to move the bitcoin that resides at that address. For example, with a 2-2 multi-signature address, two people would need to agree to sign for funds at that address in order for them to be spent.
Bitcoin Lightning Network: an analogy
With this payment channel in the Lightning Network, only the first and last transaction are included in the Bitcoin blockchain. All other transactions between the first and last transaction take place off-chain, i.e. outside the Bitcoin blockchain. These transactions between first and last are called commit transactions and are not limited by Bitcoin protocol fees or transactions per second.
A comparable process would be to open an account at a bar. Instead of paying for each drink individually throughout the evening, which takes longer and costs more in the form of transaction fees, an initial account or payment channel is opened and tracked. updated with every drink order. The invoice is then settled in a single transaction at the end of the evening. Closing the bill at a bar is similar to closing a payment channel on the Lightning Network.
Other Benefits of the Lightning Network
With the Lightning Network, payments can be routed through multiple channels to any of the network participants. For example, if a payment needs to be made to someone but no direct channel is available, it can still be routed through another network participant.
The speed of the Lightning Network also enables micro-payments, where payments can be made in increments at specific time intervals. Service providers could now charge by the minute instead of monthly subscriptions, or employers could pay for work performed almost immediately instead of writing a weekly paycheck.
With the benefits brought by the Lightning Network, the number of users has also increased significantly. There are currently around 36,000 nodes on the Lightning Network with a network capacity of 3,600 BTC.
There are many wallets, with or without custodial options, that allow Lightning Network payments.
Some of the best are Strike, Bluewallet, Cash App and Muun. An important point to note is that Lightning QR codes are somewhat different from on-chain Bitcoin QR codes. Some newer wallets allow switching between On-Chain Bitcoin and Lightning Network Bitcoin. Failed transactions are often caused by users sending their BTC to the wrong type of address.
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