Bitcoin users are familiar with the Lightning Network, which is a notable Bitcoin L2 that was created to help scale the Bitcoin blockchain by handling small peer-to-peer transactions.
Like other Bitcoin L2s, the Lightning Network's primary purpose is to take transactions off the Bitcoin Layer 1 (also called L1), funnel them to the L2 layer where they will be processed, and then settle back to the L1 once the transaction data has been processed.
What is the Lightning Network?
Launched in 2018, the Lightning Network is an L2 solution that was designed as a peer-to-peer system in which two parties could send quick and cheap micropayments to each other without having to rely on an intermediary to conduct extensive security checks, block confirmations, and settlement finality before approving the transaction.
The Bitcoin L1 can only process about seven transactions per second. As a result, it generally takes about 10 minutes for Bitcoin transactions to be confirmed on-chain, and about 1 hour for settlements to be finalized depending on network traffic.
In a minority of cases, a user sending assets may have to pay a transaction fee bigger than the payment itself if network congestion is high enough. Ultimately, transactions made on the Bitcoin L1 can be inefficient, slow, and even expensive for parties who want to exchange quick and easy payments with each other.
The Lightning Network was developed to address these issues and give Bitcoin users a more efficient way to conduct transactions on the blockchain.
How Does the Lightning Network Work?
Instead of processing every transaction through the Bitcoin L1, the Lightning Network uses smart contracts and real Bitcoin transactions to create an entirely new layer dedicated specifically to exchanging fast and cheap micropayments.
These small transactions are made possible on the Lightning Network thanks to multi-signature payment channels.
Multi-signature payment channels
A payment channel on the Lightning Network is created when two parties agree to fund a multi-signature wallet on the main blockchain. Once the channel has been set up, the two Bitcoin users can send as many micropayments to each other as they desire without needing to inform the main blockchain.
Instead, every time a transaction is made, both parties need to sign off on it so that the balance of funds can be updated on the payment channel. The Lightning Network records all exchanges made throughout a payment channel’s entire transfer history.
There are two types of payment channels that users can take advantage of:
Direct Channel: A payment channel used between two Bitcoin users who send transactions to each other often.
Interconnected/Indirect Pathways: Payment channels used for either one-off payments or peer-to-peer exchanges with users who don’t interact with each other as frequently.
If one of the users decides to close a payment channel, each party’s final balances are consolidated into one final closing transaction. That data is then sent off to the main Bitcoin blockchain. This is one of only 2 transactions processed on the Bitcoin L1 with the other one being the transaction that opens a payment channel on the Lightning Network.
Additionally, smart contracts manage the opening and closing of a payment channel, ensuring that both parties adhere to the rules.
Pros and Cons of the Lightning Network
Pros
Considering that the Lightning Network is a system designed specifically for everyday peer-to-peer transactions, it addresses a number of challenges present on the Bitcoin L1. These include:
Quicker Bitcoin transactions: The Lightning Network measures finality in seconds instead of minutes/hours, meaning that payments and settlements can be made almost instantaneously and without needing to go through extensive security checks.
Lower transaction fees: The transaction fees in the Lightning Network are only 1 Satoshi (1 sat), which are much lower than the fees a user would have to pay on the Bitcoin L1 for transactions to be confirmed, especially if the network is congested. The transaction fees have remained this low thanks to the Lightning Network’s high output.
Scalability: In theory, the Lightning Network can process about one million transactions per second, making it more efficient than any current legacy system.
Cons
However, while the Lightning Network provides some remarkable benefits, it is not a perfect system as it comes with some potential risks. While efforts are being made to address these issues, some of the biggest possible drawbacks users may face include:
Costs: While using the Lightning Network itself is cheap and efficient, setting up a payment channel can be costly. On top of the actual transaction fees, there are also routing charges for transferring payment information between Lightning nodes and opening/closing channels.
Potential risk of centralization: While service providers and large nodes like watchtowers mitigate the risks of using the Lightning Network, there are concerns that they also could potentially lead to the system becoming more centralized.
Conclusion
The Lightning Network was created specifically to allow users to send quick, cheap, and easy micropayments to each other almost instantaneously. Rather than having these small transactions go through the main Bitcoin blockchain, they could instead be funneled through multi-signature payment channels.
The Lightning Network – and Bitcoin L2s more broadly – represent a significant step forward in enhancing Bitcoin’s scalability. While it still is in the early stages of development and adoption, it has the potential to change the users engage with their assets for everyday transactions.