It’s a known fact that Bitcoin is the most popular cryptocurrency on the market. However, with only 7 transactions per second, the pressure and the overloading on the blockchain created the need for the Layer 2 Lightning Network.
Before being confirmed by miners, Bitcoin transactions sit in a memory pool (mempool). Because of the intensive trading and countless transactions taking place, the network is sometimes facing dramatic spikes in transaction activity. And that makes the mempool congested.
The mempool congestion results in a tremendous number of transactions waiting to be included in the next block. And at times like this miners prioritize bigger transactions with bigger fees. So the users that casually spend $50 worth of Bitcoin find themselves compelled to pay very high fees to have their transactions recorded promptly.
While Bitcoin’s network usually confirms transactions every 10 minutes, if you don’t pay a high enough fee during busy times, your transaction can take several days to be confirmed.
Table of Contents
What is the Lightning Network?
The Lightning Network can be defined as a set of rules that are built on top of Bitcoin’s blockchain that are specifically designed to handle micropayments.
It works as a second off-chain layer that records small transactions inside a dedicated channel, similar to a soft fork. After all the micropayments take place, the Lightning Network will broadcast the final settlement on the main chain.
The Lightning Network appeared for the first time in Joseph Poon and Thaddeus Dryja’s whitepaper in 2015 as a system that allowed for decentralized high-volume payments using Bitcoin.
The most prominent implementations of the Lightning Network come from Blockstream, Lightning Labs, and ACINQ, with input from other members of the Bitcoin community.
And although it was originally designed specifically for Bitcoin, the technology is currently being developed for other cryptocurrencies such as Stellar, Litecoin, Ether, and Ripple.
Lightning Network works as a layer 2 solution for Bitcoin
Introduced in 2015 and still under development, Bitcoin Lightning Network proposes a system in which small transactions don’t need to be recorded on Bitcoin’s Blockchain, but off-chain.
The layer 2 off-chain focuses on Payment Channels between two users that open up an off-chain direct channel between them.
The channel remains open and the two users can send payments back and forth as they like, without the data overloading the main Blockchain. This way, funds can be transferred as quickly as their wallets can communicate.
Once the two users want to conclude their business, they close the channel and broadcast a final closing transaction on the main blockchain that settles all previous transactions.
Think of this system like two people writing on a paper how much they owe each other. Once they reach a conclusion, they go to the bank to make the final transaction.
Lightning Network Payment Channels
So, when opening a payment channel off-chain, the involved users make a deposit on the layer 1 blockchain that acts as a security deposit. The deposit has to be equal to or larger than the value that will be transacted.
If at any point one of the users wants to back out of the transaction, he can simply take his deposit without consulting the other user.
The transactions are signed on the off-chain ledger stating what amount was transferred to whom.
Once the transaction is concluded, the signed ledger can be closed on the main blockchain and the deposits will be returned according to the new balances.
Regardless of the number of transactions that happened on the off-chain, the blockchain will only show 2 transactions: one for opening the payment channel and making a deposit, and one for settling the final transaction.
The fraud protection mechanism
After a transaction is signed, if one of the users tries to cheat the other and pull out his deposit, the cheater will lose all of his deposit in favor of the honest user. This is to discourage participants from trying to cheat.
The Routing Nodes
Following the basic way the Lightning Network works means that you would have to deposit funds with each new person you want to transact with.
To overcome this issue, the lightning network allows a user to connect to people through intermediary channels.
So let’s say person A wants to send some BTC to person D through the lightning channel. In this case, person A doesn’t have to open up a new direct channel but find its path. So if A is connected to person B, B to C, and C to D, person A can reach person D through B and C’ channels.
This network effect employed by the lightning network makes the system globally scalable
When will Lightning Network be activated on Bitcoin?
People have already sent Bitcoins through Blockstream’s, Lightning Labs’ and ACINQ’s implementation of the Lightning Network.
But the question of when the Lightning Network will go live on Bitcoin has a debatable answer. In fact, the Mainnet was launched in 2018 and the Lightning Network has seen impressive growth, despite many considering it to still be in beta.
As of June 2020, there are 5,606 routing nodes and 32,948 channels around the world.
Source: LIGHTNING NETWORK EXPLORER
However, the network is still very much in the testnet because the current implementations are buggy and there’s no software with which casual users can make transactions.
And when it comes to trading, there are few to no exchanges that are willing to implement it because of the channel cap.
Will BTC Lightning Network have fees?
Bitcoin miners have two sources of income:
- The reward from creating a new block which gets lower with every halving;
- The fees from the transaction confirmation.
And although at first hand it looks like The Bitcoin Lightning Network will take away the fee-based income source, that’s not really the case.
The on-chain will broadcast an opening transaction and a closing transaction. So the confirming transaction confirmation will still stand. But the network won’t overload with tiny countless transactions.
That’s because at the moment, you can end up paying a $50 fee for transferring $50 if the network is overloaded.
So, to make BTC friendly to the casual users, a small $50 transaction can take place off-chain. After 10 transactions the channel can be closed at a less busy time and broadcast $500 with a small fee.
When it comes to Bitcoin Lightning Network transaction fees, the Routing Fee Economics is quite complex. Depending on the nodes and the length in the route you chose you can end up paying no fees or a small fee for an instant transaction.
The fees are established by the routing nodes and they pile up depending on the route you take. They are either fixed, like 1 satoshi per transaction, or a percentage of the amount transferred.
Pros and Cons
The Lightning Network is not perfect, but it comes to solve the scalability issue that most cryptocurrencies currently face.
The fees are considerably smaller on the Lightning Network, allowing Bitcoin to be used for casual small spendings.
The instant transactions brought by the Lightning Network’s direct channels are meant to help users settle transfers at the same moment without awaiting confirmation for the smallest spendings.
The insane scalability proposed by the Lightning Network supposes that the Lightning Network will be able to handle heights of at least 1 million transactions per second.
The Lightning Network is not operational. Although the mainnet was launched in 2018, it’s still buggy and is used only by some advanced users.
The complexity of channels can get overwhelming. If you do not open a direct channel to another user, but use intermediary channels, you will obtain a route formed by several routing nodes. Although you chose the route, the fees still pile up, and sometimes it can feel more expensive using the Lightning Network than the main blockchain.
The Channels on the Lightning Network are capped. A channel holds only as many Bitcoins as the participants deposited. So, for an entity like an exchange that needs to handle transfers that involve large amounts of coins, the Lightning Network is barely usable.