What Is the Lightning Network? A Guide to Bitcoin’s Scalable Payment Channels

November 5, 2021


What Is the Lightning Network? A Guide to Bitcoin’s Scalable Payment Channels
The Lightning Network is a scaling layer for Bitcoin payments. This guide explains how the Lightning Network came to be and how it works.

Early in Bitcoin’s lifetime, it became evident that the underlying blockchain architecture wasn’t scalable. The very first questions over Bitcoin’s scalability emerged even before the genesis block, in response to the publication of the white paper which positioned BTC as a “peer-to-peer electronic cash system.”

The problem is that for BTC to replace cash, it must be a suitable medium of exchange as well as a store of value. While Bitcoin has come to fulfill the latter criteria over the years, its lack of scalability means that it’s not an effective medium of exchange.

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Time is an issue—it takes minutes for a transaction to be confirmed into a block and added to the ledger. But worse, the risk of double-spending means that most merchants would prefer to wait for several blocks to be confirmed, or up to an hour, before they’re prepared to consider a transaction final. There’s also the potential deal-breaker of Bitcoin’s fees, which are too high to make BTC payments economical. 

From either side of the transaction, it’s simply not viable. Therefore, the Lightning Network came about as a means of making Bitcoin payments faster and more scalable. 

How the Lightning Network Works

In 2015, Joseph Poon and Thaddeus Dryja published a whitepaper that proposed the Lightning Network, using off-chain payment channels to enable near-instant payments without congesting the Bitcoin network each time. 

When two users want to transact in BTC quickly, they can open up a payment channel between themselves and send payments near-instantly and with almost zero fees. Because these transactions aren’t recorded on the main Bitcoin blockchain, they aren’t held in a queue waiting to be confirmed. When the two parties decide to close the channel, Lightning Network nodes update the Bitcoin network with the net balances of both accounts to reflect the net total of the transactions that have been performed off-chain. 

Under the hood, there are smart contract-based mechanisms to ensure that both parties can make good on their side of the transaction. The off-chain channel is effectively a funded wallet with a shared master key. Lightning can also support transactions in this way between multiple parties, creating a network of payment channels. 

Development of the Lightning Network

Poon and Dryja found Lightning Labs in 2016, but by then, their work had already caught the attention of other developers. Lightning development shops were set up in Blockstream, a company called ACINQ, and later, Bitfury.

Unfortunately, the development of Lightning Network went on to become caught up in the growing feud among the Bitcoin community over block size. Although the implementation didn’t depend on Bitcoin’s block size, Lightning required a specific upgrade to the network to enable the payment channel smart contracts. This upgrade eventually became part of the Bitcoin SegWit hard fork, which went live in 2017. 

A beta of Lightning launched in 2018, and Twitter’s Jack Dorsey became an early supporter. However, it’s fair to say that it hasn’t been plain sailing for the network over recent years. 

Teething Problems

In 2019, a group of Hungarian researchers published a paper that found that due to low network adoption, estimated revenues for running a Lightning node were so low as to make it uneconomical. As a consequence, the transaction fees levied by nodes made payments prohibitively expensive. But the biggest problem is that this scenario risks leading to a vicious circle of lack of adoption. Without enough nodes to keep transaction costs low, the network couldn’t attract users. Without users, the revenues for running a node wouldn’t be attractive enough to bring in a sufficient number of nodes to lower the fees. 

The lack of throughput also made it easy to identify transactions, compromising user privacy. The network has also been beset by other challenges, perhaps most notably the rise of DeFi and a slew of innovation and funding around other digital payment solutions, both centralized and decentralized. 

The rise of the Lightning Network

However, having the support of someone as influential as Jack Dorsey has perhaps been Lightning’s savior. In September this year, Twitter launched a feature allowing users to tip using the Lightning Network in any currency. This means users don’t even have to hold BTC (the currency) to take advantage of Bitcoin (the network’s) instant permissionless global settlements thanks to the Lightning Network. 

The adoption of Bitcoin as a national currency in El Salvador also shows significant promise for the network to increase its usage. The country’s president believes that his move to Bitcoin adoption could cost remittance providers up to $400 million, representing a significant saving for users. 

Over the last 12 months, the total value locked in the Lightning Network increased by 10 times, from under $15 million to over $160 million. While that’s impressive growth, it’s still a drop in the ocean compared to BTC’s trillion-dollar market cap. Nevertheless, analysts predict that the El Salvador move could increase usage to 700 million people by 2030. 

Recent developments are certainly encouraging, particularly in terms of adoption and user experience. However, like any blockchain-based application, the Lightning Network will require a certain scale of adoption before it can be considered a success.

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