Why do we need the Bitcoin Lightning Network?

The Bitcoin Lightning Network is gaining broader acceptance.

The Bitcoin Lightning Network is gaining broader acceptance. In this article, you’ll learn how these lightning-fast transactions work and why they’re becoming increasingly important in our daily lives.

Introduction

The Bitcoin Lightning Network is growing in popularity. Adoption and deployment of Lightning is progressing steadily. Despite fluctuating Bitcoin prices, there are currently more than 4.800 Bitcoin in the Lightning system, with a value above 90 million US dollars. There’s also growing institutional activity around the Lightning network. Lightning Labs, for example, which plays a key role in developing the protocol, raised $70 million in Series B funding earlier this year. The number of companies offering Lightning services is growing rapidly.

Bitcoin as a Global Monetary System?

Bitcoin offers a range of advantages as a decentralized monetary system that can send money worldwide without intermediaries. It features low barriers to access: anyone with an internet-connected device can use the Bitcoin protocol. No one can be excluded, which has a positive effect on financial inclusion. Bitcoin is also a scarce digital asset, a kind of "digital gold." Each bitcoin can be divided into 100 million satoshis, just as a euro can be divided into 100 cents. Unlike fiat currencies, the money supply according to the Bitcoin protocol is capped at about 21 million Bitcoin. So “devaluation through dilution” is impossible.

Despite these benefits, the current state of technology also has drawbacks. For transactions on the Bitcoin blockchain, network decentralization comes at the expense of transaction throughput, i.e., the number of transactions that can be processed per second. In total, a maximum of seven on-chain transactions can be confirmed per second through the Bitcoin network.

To function as a payment system, this throughput is not enough. Established payment providers like Visa or Mastercard enable several thousand transactions per second and are therefore much more scalable, even if they are fully centralized. Payments typically take longer to be confirmed (mined) and are therefore not suitable for daily payments. Another limitation is small Bitcoin payments. Each transaction incurs a fee based on the amount of memory used. The more memory used, the more expensive the payment. On average, a transaction currently costs about 1 US dollar, regardless of volume. In times of rising demand, such as 2017, transaction costs peaked at more than 60 US dollars. For large payments, fees may seem cheap, but small payments are usually uneconomical due to the share of transaction costs.

The Lightning Network Enables Everyday Bitcoin Usage

The goal of Lightning is to make Bitcoin suitable for everyday use as a payment method. The top priority is increasing transaction throughput without centralization, as seen with payment networks like Visa or Mastercard. This means more payments under favorable terms. While Bitcoin’s whitepaper was published by Satoshi Nakamoto in 2008, the Lightning Network concept dates back to 2015. The first implementations began in 2016, with initial usage of the implementations in 2018. Since then, the technology and network have evolved quickly. Yet despite its growing size and adoption, it was still in its early stages in 2022.

How does Lightning solve the problem of low transaction throughput and relatively high transaction costs? Not all payments are written to the blockchain (i.e., they are "on-chain"), but payments are made off-chain and are only written to the blockchain in extreme cases or when a financial relationship between two network participants is terminated. User payments can be processed in real time and at low cost. Users sending money via Lightning don’t have to wait for the mining process. Payments are processed directly to the end recipient.

How the Lightning Network Works

The following practical example illustrates how Lightning works. Alice goes to a bar with friends and wants to invite them all. But it’s too much trouble for her to pay for every drink individually. Alice leaves her credit card at the bar. Each drink for the group is recorded by the bartender. At the end of the night, the bartender runs a bill for all the drinks, which Alice ultimately pays. This type of payment, called opening a tab, is common in the US and the UK.

This example bears some resemblance to how the Lightning Network operates: People send IOUs to other people or merchants or restaurants via so-called payment channels (off-chain). In theory, an unlimited number of IOUs can be exchanged between the two parties. Eventually, the payment is settled on Bitcoin (on-chain). The example is somewhat misleading, because the Lightning Network can do a lot more: it doesn’t require trust in the other party, and you can also make payments to people with whom no direct payment channel exists via routing.

Conclusion

The Lightning Network is the next evolutionary step for Bitcoin. Bitcoin enables worldwide transactions without intermediaries, but processing all payments through the Bitcoin blockchain has limitations. Lightning can dramatically increase throughput: a prerequisite for it to be used on a large scale as a payment system. With Lightning, small payments can be made at a fraction of the cost, laying the groundwork for a whole micro-payment economy.