What is Lightning Network and How Does it Work?

2021/04/29 10:13:47

Bitcoin reigns supreme. However, challenges such as Ethereum and Polkadot are winning grounds too. These blockchains promise faster transaction throughputs and faster transaction finality time. Avalanche, for example, boasts just one second for transaction finality compared to Bitcoin’s sixty minutes (or six blocks), as well as larger transaction throughput – 4,500 per second, compared to Bitcoin’s seven transactions per second.

Ardent Bitcoin ambassadors understand that Bitcoin wasn’t built to replace or compete with centralized systems such as Visa. Bitcoin is a conservative decentralized network slowly evolving into becoming an alternative monetary system. But network congestion has proven too large of an issue to ignore solely on ideological grounds. Therefore, Bitcoin too has been recently introducing solutions to speed up transaction time and reduce network congestion.

One such solution is the Lighting Network. Others include Ethereum-centric protocols such as Raiden Network and the Connext network.

What is Lightning Network?

Lightning Network is a so-called Layer 2 solution, built on top of Bitcoin. A “second layer” runs on top of the blockchain’s original network (“layer 1”) and syncs with it. In comparison, Layer 1 is the base blockchain layer. Lightning network is a Layer 2 protocol that is added on top of Bitcoin to enable instant transactions between nodes in a blockchain. Bottlenecks of a Layer 1 solution are bypassed without sacrificing the base layer’s main qualities. Lightning network comes as a solution to Bitcoin’s persistent scaling issues designed to reduce transaction fees while making it easy for people to send and receive instant payments.

It is important to make a difference between Layer 2 networks and Sidechains.

Layer 2 Networks vs. Sidechains

Layer 2 Networks rely on the security of the underlying chain, which provides a security guarantee. Sidechains are independent blockchains that rely on their security and consensus algorithm (Proof of Authority, Delegated proof-of-stake, Byzantine fault tolerance, etc.,) but they are *interoperable* with the main chain. Sidechains provide greater flexibility, much cheaper transactions, and high throughput. While they may offer better blockchain specs, such as improved block time and throughput, they still suffer from inefficiency due to on-chain workloads. Some of the more well-known sidechains are Liquid and Polygon (formerly Matic).

Layer 2 Networks such as the Lightning network are somewhat limited by the rules of the underlying chain and have a much complex design approach to make things work. However, both L2 Networks and Sidechains are viable scalability solutions with their own set of limitations. Rollups (ZK rollups, Optimistic rollups), State Channels, Plasma, and Validium are examples of the L2 Networks. Skale, PoA Network, and Matic are examples of the sidechains. Prolific names in this domain like Michael Saylor, Andreas Antonopoulos, Stephan Livera, Paolo Ardoino, and others believe Layer 2 protocols such as Lightning network are the way forward, and that they could turn into one of the biggest solutions in the entire crypto space.

To further understand the Lightning network, we will use an analogy from traditional finance.

You go to Starbucks and order a cup of coffee. You pay with your Visa card. In that same hour or day, thousands of people may get a Starbucks cup of coffee anywhere in the world. Settling each of these numerous microtransactions would clog the network within minutes. Therefore, Visa groups them into blocks or batches and settles them through the banking system in regular intervals, such as once a week or even once a month.

The banks then settle who owes what to whom through the so-called settlement layer, an interbanking system of obligations. Can you recall so-called Clearinghouses? That’s what they do. An example would be the United States of America’s Fedwire.

A similar analogy applies here. The Lightning network is a protocol that would serve as the transaction layer. Millions of smaller transactions would be bundled together and then settled at once on the settlement layer – the Bitcoin network. Therefore, the Lightning network is Visa and the base (Bitcoin) layer is Fedwire.

How does the Lightning Network Work?

To begin with a Lightning network transaction, there must be two people looking to transact with each other using Bitcoin. Both will have to set up a MultiSig wallet, which is to be used as a storage facility for the bitcoin being transacted. Once a wallet address is saved on the blockchain, a setup payment channel is launched where two parties can conduct an unlimited number of transactions without moving information stored on the blockchain.

After each transaction is completed, every party involved in a Lightning network transaction must sign an updated balance sheet to indicate how much of the bitcoins stored in the wallet belongs to them. The channel closes when the two parties have finished transacting.

The resulting balance on completion of the transaction would only be reflected in the blockchain on the closure of the channel.

Closing Thoughts

Lightning Network could bring Bitcoin improved performance, lower fees, and the ability for its users to run a Lightning node from almost any device. While it is true that some crypto enthusiasts dislike the Lightning Network, no one can deny that such a solution could greatly improve Bitcoin’s slow blockchain if it manages to solve its persistent scalability and network congestion issues.

However, only time will tell how successful and utilized the Lightning Network will be in the future.