Bitcoin's Lightning Network (LN) is a second layer added to Bitcoin's network enabling transactions to be done between parties off of the blockchain—called off-chain transactions. Lightning Network has been often considered a game-changer in the cryptocurrency’s evolution. It is designed to speed up transaction processing times and decrease the associated costs of Bitcoin’s blockchain. The lightning network was conceived by two developers, Thaddeus Dryja and Joseph Poon, back in 2015.

Although the Lightning Network has experienced growth and development since its inception, challenges remain. Bitcoin's price fluctuations have prevented the crypto from becoming a widespread method of payment for consumer and business transactions. Also, there are costs involved in using Lightning Network since transactions still need to be done on the blockchain.

In this article, we highlight why the Lightning Network is needed and three problems that the network is facing. Also, we review the future of Bitcoin's Lightning Network by exploring recent technological developments that could impact and improve the network in the years to come.

Key Takeaways

  • Bitcoin's Lightning Network (LN) is a second layer added to Bitcoin's network enabling transactions to be done off of the blockchain.
  • Lightning Network is designed to speed up transaction processing times and decrease the associated costs of Bitcoin’s blockchain.
  • However, Lightning Network still has costs associated with it and can be susceptible to fraud or malicious attacks.
  • Bitcoin's price swings may prevent the crypto from becoming a popular method of payment limiting the use of Lightning Network.

Understanding Bitcoin's Lightning Network

As Bitcoin gains popularity, more and more transactions are processed on its blockchain network. Blockchain technology is essentially a shared database in which its distributed ledger allows participants to see all of the transactions that have been recorded. The transactions that are done on the blockchain network are called on-chain transactions.

Having copies of the data distributed to network participants helps to prevent issues and disputes regarding transactions as well as prevent fraud. For example, if someone hacked into the network and changed a transaction's details, copies on the distributed ledger could be reviewed and the fraudulent transaction could be stopped.

Bitcoin's Scalability Issue

However, as all of the participants or nodes receive copies of the transactions, the process of validating the transactions by every node—called miners—in the network can bog down the system, particularly during periods of high transaction volume. As a result, Bitcoin has faced a scalability issue, meaning there are challenges when the network tries to process more transactions simultaneously. In order for Bitcoin to move to the next level and process more data, the network needs to build scale, which would allow more transactions to be processed quickly and efficiently.

The latency in the network has led to higher transaction fees as miners take longer to validate transactions. Also, participants can sometimes pay a higher fee to have their transactions processed faster. Bitcoin's Lightning Network was introduced to help improve the processing times, build scalability, and lower the network's transaction fees.

The Lightning Network

In a nutshell, the lightning network allows participants to transfer bitcoins between one another without any fees using their digital wallets. Payment channels are created between the two users so that they can transact with each other—in other words, off-chain transactions. Lightning network is another layer added to Bitcoin's blockchain so that it can process micropayments between participants.

The goal of the network was to create channels in which payments could be made between users without any fees or delays. By allowing the transactions to be done off-chain, the processing time and the number of transactions done via the on-chain network would be improved.

Diagram describing how the Bitcoin Lightning Network functions.

1. It Does Not Completely Solve Bitcoin’s Transaction Fee Problem

Lightning Network is often touted as a solution to the problem of bitcoin’s rising transaction fees. Its proponents claim that transaction fees, which is one of the direct consequences of Bitcoin’s clogged network, will come down after the technology takes transactions off the main blockchain. But bitcoin’s congestion is one among several factors that influence its transaction fees. Besides, the cryptocurrency’s fee itself is a large component of the lightning network's overall costs.

Opening and Closing Channel Costs

Specifically, there are two parts to their costs. The first part consists of a fee equivalent to Bitcoin’s transaction charges in order to open and close channels between parties. Although the lightning network allows payments between two parties, an opening transaction or deposit must be made via on-chain. The two parties then can process multiple transactions between each other, but once the bill has been settled, they need to record a closing transaction for the settled amount on the blockchain.

Routing Fees

Besides the transaction fees to open and close channels, there is a separate routing fee to transfer payments between channels. Since the fees for the lightning network are quite low, in theory, it should attract more participants. However, if the fees are so low for the routing of payments between nodes, there might not be any incentive for the nodes to facilitate the payments. Also, as businesses adopt the lightning network as a method of payment, they may also charge fees.

This problem contrasts with the approach being taken by other cryptocurrencies to increase their payments business. For example, Dash has free software plug-ins for merchants to download and use. Dash uses Masternodes, who must have deposited 1,000 in Dash coins so that they can approve transactions very quickly. The fees for users are approximately two cents per transaction and Dash payments are available at more than 4,000 merchants.

2. Remaining Online At All Times Makes Nodes Susceptible

Nodes on Bitcoin’s lightning network are required to be online at all times in order to send and receive payments. Since the parties involved in the transaction must be online and they use their private keys to sign in, it's possible that the coins could be stolen if the computer storing the private keys was compromised. However, cold storage of coins, which is considered the safest method for storing cryptocurrencies, is possible on a lightning network.

Offline Transaction Risk

Going offline creates its own set of problems on the Lightning Network. According to Dryja, it is possible for one of the two parties from a payment channel to close the channel and pocket funds while the other is away. This is known as Fraudulent Channel Close. There is a time period to contest the closing of a channel, but a prolonged absence by one of the parties could result in the expiry of that period.

Malicious Attacks

Another risk to the network is congestion caused by a malicious attack. If the payment channels become congested, and there's a malicious hack or attack, the participants may not be able to get their money back fast enough due to the congestion.

According to Dryja, "forced expiration of many transactions may be the greatest systemic risk when using the Lightning Network."

If a malicious party creates numerous channels and forces them to expire at the same time, which would broadcast to the blockchain, the congestion caused could overwhelm the capacity of the block. A malicious attacker might use the congestion to steal funds from parties who are unable to withdraw their funds due to the congestion.

3. Bitcoin's Price Fluctuations 

The advent of Lightning Network is also supposed to herald Bitcoin’s viability as a medium for daily transactions. Customers are able to open payment channels with businesses or people that they transact with frequently. For example, they can open payment channels with their landlord or favorite e-commerce store and transact using bitcoins.

However, Bitcoin still has ways to go before gaining mainstream traction. The increase in its transaction volumes is largely attributed to a rise in trading volumes. In other words, Bitcoin's popularity is a double-edged sword since the increased attention garners investment but also attracts more traders increasing the volatility or price fluctuations in the cryptocurrency. The price volatility makes it challenging for companies to use Bitcoin as a method of payment when pricing their products to sell to their customers or to purchase inventory from their suppliers.

For example, let's say a company has to pay an invoice to their supplier of bitcoin. Typically, suppliers give their clients time to pay, such as 30 days. If bitcoin's price has increased by 10% during the 30 day period, the business has to come up with another 10% worth of fiat currency or another cryptocurrency to convert to Bitcoin and pay the invoice to pay the supplier. This exchange risk exists because the business might be paid by their customers in a fiat currency and not Bitcoin. The exchange risk also exists for consumer transactions since the salary or wages for most individuals are not paid in Bitcoin, leading to transactions being converted from a fiat currency to Bitcoin.

As a result, the overall effect of Lightning Network on reducing Bitcoin’s transaction fees and building scale may be limited since the crypto has yet to be adopted as a method of payment.

The Future of Bitcoin's Lightning Network 

There remain challenges with Bitcoin's Lightning Network and its ability to boost scale while simultaneously lowering transaction fees. However, the technology’s core team has incorporated new use cases and has been researching additional features. As a result, there have been significant developments that are due to improve the network in 2021 and beyond.

Larger Payments via Lightning Network

Lightning had initially limited channel size to a maximum of 0.1677 BTC but in 2020, it was announced that the constraints will be removed so that clients can have larger channels. These "Wumbo" channels are designed to increase the usage and utility of Lightning Network for consumers and businesses.

Crypto Exchanges

One of the most promising initial use cases to emerge involves cryptocurrency exchanges. In December of 2020, Kraken exchange announced that it will begin supporting Lightning Network in 2021. At first, only withdrawals will be allowed as they get systems acclimated, but payment channels may become possible so that Lightning transactions can be done directly with the exchange.

Watchtower

Watchtowers are third parties that run on nodes to prevent fraud within Lightning Network. For example, if Sam and Judy are transacting and one of them has malicious intent, they may be able to steal the coins from the other participant. Let's say Sam and Judy put up an initial deposit of 10,000 bitcoins and a transaction of 3,000 has taken place in which Sam purchased goods from Judy. If Judy logs off her system, it is open to possible fraud. Sam could broadcast the initial state, meaning they both get their initial deposits back as if no transactions were done. In other words, Sam would have received 3,000 BTC worth of goods for free.

This process of closing the channel based on the initial state versus the final state in which all of the transactions have been done is called fraudulent channel close. The watchtower or third party can monitor the transactions and help prevent fraudulent channel close.

The Bottom Line  

The Lightning Network is an ever-evolving concept that is likely to make a significant difference to Bitcoin’s blockchain. However, the network might not be the solution to all of the challenges facing Bitcoin. Also, as new changes and improvements are made to the network, there's the potential for new problems within the cryptocurrency’s ecosystem. Much will depend on the research and development of new technology in the future.