Bitcoin has progressed through several phases of differing usage over the past decade. What started as a peer-to-peer payment network soon transformed to a digital store of value. To be used as money in everyday transactions, external solutions such as the Lightning Network are crucial.
Widespread usage of bitcoin as money requires it to be useful as such. For bitcoin to reach its final monetary form, it is not sufficient to be a store of value alone (as is currently the case with gold), it also needs to be a viable medium of exchange. As part one of this article has shown, the network isn’t suited for fast and cheap payments. It relies on external solutions, the most popular one being the Lightning Network.
How does the Lightning Network work?
Lightning’s core innovation is its use of payment channels. These allow two trading parties to freely transact in a peer-to-peer manner, using bitcoin, but without needing to use Bitcoin’s hefty finality process for anything other than initiating and ending a series of trades. This works similar to a pre-funded tab of sorts, whereby each entity continuously tracks a history of payments as they’re streamed back and forth. Then, should they wish to conclude their trading partnership, they submit the final balance to the Bitcoin blockchain and undergo its robust settlement process.
In other words, payment channels enable one opening, and one final settlement transaction, to encompass many historical trades. This increases the economic density of the bitcoin transactions and splits its fees across a potentially unlimited amount of individual payments.
The Lightning Network operates as a second layer atop Bitcoin where each participant recognises the same native unit and uses it to make exchanges. Importantly, as an extension to Bitcoin, Lightning doesn’t have or need its own blockchain. Rather, it relies on Bitcoin for its security in finalising transactions. In this way, Lightning is subscribing to a judiciary service offering, where Bitcoin’s layer one acts as the final arbiter to any disputes on Lightning’s layer two. In other words, if there’s a disagreement within a payment channel, Bitcoin issues a verdict in accordance with its rules.
The channels we’ve explained above are bidirectional, meaning they only involve two parties sending money back and forward between each other. However, bidirectional payments channels are not sufficient to create a globally viable payments network. So to improve bitcoin’s use case as a transactional currency, Lightning expands beyond its core concept of bidirectional payment channels to networked multidirectional channels, where payments can be routed in hops across multiple channels, similar to how packets of information are routed across the internet.
Lightning creates a mesh network of interconnected users, and payments can travel from one to any other Lightning user as long as there exists a route of open payment channels connecting the two. For example, if Alice has an open channel with Bob, Bob has one with Carol, and Carol has one with Dave, Alice can pay Dave by using Bob and Carol as payment routing intermediaries.
For this to work efficiently, payment channels require liquidity. As briefly mentioned above, each payment channel is constructed with a pre-loaded, fixed amount of bitcoin. The two entities entering their trading partnership set a capacity limit to their channel as they fund it with a bitcoin transaction. Thus, as payments are streamed back and forth, there is an inherent limit to the size of each payment. One’s limit is reflective of the capacity in the total channel, as well as their current balance within the channel. To visualise this concept, consider an ancient mathematical tool: the abacus.
In this example, a payment channel is represented by a single wire on an abacus. The channel’s capacity is then explained by the total amount of beads strung on that wire, and each channel partner’s available balance corresponds to the amount of beads that reside on his/her side.
Channel liquidity along the route of an intended payment therefore becomes an influential measure of the Lightning Network’s ability to facilitate said payment. All channels along the intended path must have the necessary capacity to handle it in the desired direction. So long as there are available channels with necessary liquidity, and a more or less circular economy in the system, Lightning can handle an effectively unlimited transaction flow, and these transactions can be arbitrarily small and frequent.
Lightning’s improvements for Bitcoin
When Lightning works as visualised, it mitigates Bitcoin’s deficiencies as a high-cost, slow settlement system by adding a layered transport network for cheap, speedy payments. This is quite similar to what Visa and MasterCard do for the Federal Reserve. Most transactions in the dollar economy never touch the systems of the Fed, they are processed by payment aggregators who in turn use intermittent commercial banks, who then use the Fed for final settlement. Lightning does the same thing for bitcoin transactions, only using the Bitcoin blockchain for final settlement.
With that in mind, let’s review how the Lightning Network could fit as a puzzle piece to assuage Bitcoin’s fundamental tradeoffs.
In Bitcoin, users wait for their transactions to be finalised in a process that’s designed to prove the passage of time. The target time between blocks is optimised for robustness and reliability, not rapid transaction speeds. Hence, this scheduling dynamic requires users to sometimes accept wait periods on the order of hours.
As an alternative, using payment channels, Lightning forwards payments at the same speed as an email is sent across the internet – instantly.
Low cost transactions
In Bitcoin, transaction fees have been increasing due to network congestion and the demand to send bitcoin.
While sending a routed payment across multiple channels will incur fees, these fees are negligible and subject to competitive pressure. At the time of writing, the base fee per transaction is 1 satoshi (0.00000001 BTC), equivalent to 0.04 Cents.
High Capacity network
In Bitcoin, transactions are settled as part of a block that’s limited in size (~1.3Mb). This confines Bitcoin to linear scaling efforts where either transaction sizes or block capacity limits would need modification. While technological advancements have assisted in the reduction of transaction sizes, increasing block size would be counterintuitive to Bitcoin’s prioritisation of security and robustness.
Alternatively, Lightning removes the concept of a block such that payments are simply limited by the liquidity in each payment channel. This opens Lightning to scale horizontally as it becomes increasingly more efficient to transact when more payment channels are open and capital is efficiently dedicated to the network. Throughout 2020, Lightning’s capacity rose roughly 22% and active nodes rose roughly 41%. At the time of writing, Lightning is on pace for a record year with capacity rising another roughly 90% and active nodes another 52%.
In summary, Lightning as a second-layer inherits many of Bitcoin’s characteristics as its global, cross-border, and accessible by anyone. However, through its use of payment channels, the Lightning Network enables users to amortise the cost of a bitcoin transaction across many payments over time. We see Lightning as a critical technology that could evolve bitcoin’s usefulness in payments beyond its stigma as an investment vehicle.