What Is the Lightning Network?
Initially, Bitcoin was not designed to be scalable. It was intended to be a decentralized payment system where the users could remain anonymous and access it from anywhere. However, its popularity was one of its downfalls—transactions became much slower and more costly than intended. Thus, developers created cryptocurrency layers, where the first layer was the primary blockchain. Each layer beneath that was a secondary layer, tertiary layer, and so forth.
Each layer complements the layer above it and adds functionality. The Lightning Network is a second layer for Bitcoin that uses micropayment channels to scale the blockchain’s capability to conduct transactions more efficiently.
This layer consists of multiple payment channels between parties or Bitcoin users. A Lightning Network channel is a transaction mechanism between two parties. Using channels, the parties can make or receive payments from each other. Transactions conducted on the Lightning Network are faster, less costly, and more readily confirmed than those conducted directly on the Bitcoin blockchain.
The Lightning Network can also be used to conduct other types of off-chain transactions involving exchanges between cryptocurrencies.
- The Lightning Network is a technological solution intended to solve the problem of transaction speed on the Bitcoin blockchain by introducing off-chain transactions.
- Like a primary blockchain, the Lightning Network disintermediates central institutions, such as banks, which are responsible for routing most transactions today.
- The Lightning Network was first formally proposed in a paper by Joseph Poon and Thaddeus Dryja in 2016.
Understanding the Lightning Network
The Lightning Network was first proposed by Joseph Poon and Thaddeus Dryja in 2016 and has been under development since then. The problem the Lightning Network was devised to solve was Bitcoin's slow transaction time and throughput.
What Issues Does It Try Address?
Bitcoin wasn't created to handle the number of transactions that now occur daily. Some of the issues the Lightning Network attempts to correct are:
- Speed in confirming transactions: It has become expensive and time-consuming because there are more users transacting, and mining difficulty increases over time. The increase in transaction numbers requires improving the manner in which transactions are confirmed.
- Reduce energy requirements: The energy necessary to compute this information is enormous, making maintaining the Bitcoin blockchain prohibitively expensive.
- Introduce smart contracts and multi-signature scripts: Smart contracts and multi-sig are the backbones of the Lightning Network, used to ensure the funds sent through the channels make it to the recipients.
The Lightning Network uses channels between participants to make it so that multiple transactions can be conducted without waiting for the slower main net to confirm single exchanges. Between the opening and closing of a channel, parties can shift funds between themselves as needed until they close the channel.
Once the channel is closed, the transactions are sent to the main net for confirmation.
Concerns About the Lightning Network
The most apparent problem with the Lightning Network—which is meant to be decentralized—is that it could lead to a replication of the hub-and-spoke model that characterizes today’s financial systems. In the current model, banks and financial institutions are the primary intermediaries through which all transactions occur.
Businesses that invest in Lightning Network nodes may become similar hubs or centralized nodes in the network by having more open connections with others. Other concerns are fraud, fees, hacks, and price volatility.
Closed Channel Fraud
One of the risks when using the Lightning Network is closing the channel and going offline. For example, suppose Sam and Judy are transacting, and one has malicious intent. The dishonest party may be able to steal coins from the other participant using a technique called fraudulent channel close.
Let's say Sam and Judy each put up an initial deposit of .5 BTC to open a channel, and a transaction of 1 BTC has taken place in which Sam purchased goods from Judy. If Judy logs off (closing the channel) after transferring the goods and Sam doesn't, Sam could broadcast the initial state (the time before the 1 BTC was transferred), meaning they both get their initial deposits back as if no transactions were done. In other words, Sam would have received 1 BTC worth of goods for free—and the deposit is returned.
This makes it necessary for third parties to run on nodes to prevent fraud within the Lightning Network, called a watchtower. The watchtower monitors the transactions and helps prevent fraudulent channel close.
There are transaction fees associated with using the Lightning Network. They are a combination of routing charges for routing payment information between Lightning nodes, opening and closing channels, and Bitcoin’s usual transaction fees.
As businesses begin adopting the Lightning Network as a payment and settlement layer, they may start charging fees. Additionally, because the watchtowers are third parties, many charge fees for the service.
According to Arcane Research, Lightning Network payment volume increased 410% year-over-year for the first quarter of 2022. This increase indicates a solid user transition to payments using the network.
Once two parties settle the bill between themselves, they need to record a closing transaction for the agreed amount on the blockchain, which includes the fee charged for forwarding the transactions. This is either a base fee (a set fee) or a fee rate (a percentage of the transaction).
The Lightning Network is also believed to be vulnerable to hacks and thefts because payment channels, wallets, and application programming interfaces (APIs) can be hacked.
Individual payment channels between various parties combine to form a network of Lightning nodes that can route transactions among themselves. The interconnections between different payment channels result in the Lightning Network.
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. Attackers can also use a denial-of-service attack to congest a channel, essentially freezing it.
In these types of attacks, the attacker could use the congestion to steal funds from parties who are unable to withdraw their funds because of the network freeze.
What Is the Lightning Network?
The Lightning Network is a second layer for the Bitcoin blockchain that increases transaction times and decreases network congestion.
Can I Invest In the Lightning Network?
While you can't directly invest in the Lightning Network, private investors can invest in Lightning Labs, the company developing the network.
Who Runs the Lightning Network?
Lightning Labs, led by Elizabeth Stark, is the company that develops the Lightning Network. The network itself is deployed on the internet and runs on thousands of nodes located around the world.
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