Bitcoin has the ability to revolutionize finance around the world. Individuals and companies who transact in Bitcoin are not reliant on a bank, government, or other “trusted” third party to certify the value of the money being transferred or grant the user permission to access their wealth. Instead, Bitcoin users are able to transfer their wealth anywhere in the world at any time without needing to seek anyone’s approval and without any risk of the transaction being frozen or denied. As a result, Bitcoin is often referred to as equitable in the sense that all participants in the network are equal in power and privilege to everyone else.
Although Bitcoin has the ability to transfer large amounts of wealth relatively quickly, its blockchain is subject to certain limitations. For example, a block of transactions is confirmed on the blockchain on average every ten minutes. And until a transaction is confirmed, there is still a risk that the transferred Bitcoin might not arrive as expected. Additionally, Bitcoin’s software code only allows a certain amount of transactions to be included in each block. It’s estimated that the Bitcoin blockchain is capable of processing seven transactions per second on average, far less than the thousands of transactions occurring around the world every second.
As a result of the aforementioned limitations, Bitcoin transactions can at times become rather costly, especially when demand to use the blockchain is high. Critics of Bitcoin often throw Bitcoin’s limited transaction input around as a factor that would prohibit the cryptocurrency from ever becoming widely used or from becoming a global currency. While the base software code of Bitcoin as I’ve described is unlikely to change anytime soon, there are various technologies that are being developed to increase the scalability and usability of the Bitcoin blockchain. One of the most promising technologies is the Lightning Network.
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The Many Flavors of the Lightning Network
The Lightning Network was originally created by two developers, Thaddeus Dryja and Joseph Poon, who published their initial whitepaper describing the technology in February 2015. However, since that time the Lightning Network has gone through various iterations and there are currently a variety of entities developing the software protocol. We’ll review a few of the most well-known together:
Lightning Labs was founded in 2016 with the goal of enabling users “to send and receive money more efficiently than ever before.” They have built several products on top of the Lightning Network protocol, including a liquidity pool to increase the amount of Bitcoin that can flow through the protocol, a terminal that helps users maintain their payment channels on the protocol open indefinitely, a light client allowing wallets to verify transactions on the protocol with less impact to full nodes, and more.
The company Blockstream is not exclusively focused on developing the Lightning Network and has a variety of products including colocation services for Bitcoin mining, Bitcoin nodes validating transactions on the blockchain from space, a Bitcoin wallet, and others. However, they are also a major contributor to an implementation of the Lightning Network known as “c-lightning”, which Blockstream bills as a “lightweight high performance implementation that’s fast to compile and easy to set up.”
ACINQ was founded in 2014 in France, which means it predates the release of the Lightning Network whitepaper. Since pivoting to development on the Lightning Network protocol, ACINQ has developed its own version of a Bitcoin wallet and runs the self-proclaimed “largest Lightning node on [the] mainnet”.
How Does the Lightning Network Work?
The Lightning Network works by establishing what are called “bidirectional payment channels” between two participants on the main Bitcoin blockchain. A channel is established when each participant sends an initial amount of Bitcoin into a multi-signature transaction on the blockchain. Because the transaction is multi-signature, each participant is required to sign off on any changes to the original allocation of Bitcoin sent in by each party. However, any amount of Bitcoin transactions can be executed between the two parties before the channel is closed and the final balances are broadcast to the Bitcoin blockchain. As a result, network fees can be significantly reduced by moving the bulk of transactions off of the layer-1 blockchain and onto the layer-2 Lightning Network protocol.
An example of how the Lightning Network works in practice may be helpful. In this example, let’s assume that Bill and Susie transact with each other frequently and want to set up a payment channel to reduce the amount of fees they pay to transact on the Bitcoin blockchain. They each transfer ten Bitcoin into the channel and then perform the following transactions on the Lightning Network protocol:
Bill transfers four Bitcoin to Susie.
Bill transfers one Bitcoin to Susie.
Susie transfers two Bitcoin to Bill.
Bill transfers five Bitcoin to Susie.
Susie transfers one Bitcoin to Bill.
At the end of these transactions, Bill is left with a balance of three Bitcoin and Susie is left with a balance of seventeen Bitcoin. Rather than broadcast each individual transaction to the Bitcoin blockchain, when Bill and Susie are ready to close their payment channel they simply broadcast the final Bitcoin balances. The Lightning Network allows them to save on network fees, and final resolution on the Bitcoin blockchain allows them to take advantage of the blockchain’s security.
As a side note, the Lightning Network also allows for transactions to take place between participants who have not established a payment channel directly with one another as long as each participant has sufficient peers in common to find a path for the payment and assuming that each participant along the payment’s path has sufficient liquidity to execute the transaction:
If Bill wants to transfer one Bitcoin to Rita, he isn’t required to open a payment channel with her. Let’s assume that Susie has a channel open with Zhang who has a channel open with Rita. So,
Bill sends 1 BTC to Susie → Susie sends 1 BTC to Zhang → Zhang sends 1 BTC to Rita
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What Does the Lightning Network Actually Improve?
The Lightning Network is able to offer a variety of benefits just like or on top of those already offered by the Bitcoin blockchain:
Like the Bitcoin blockchain on which it is built, the Lightning Network is decentralized and does not mandate the participation of “trusted” third parties or the use of custodial depository solutions.
As discussed previously, the Bitcoin blockchain’s transaction throughput is limited to about seven transactions per second. The Lightning Network on the other hand has no hard limit on the number of transactions that can be performed and, in theory, is able to transact nearly an infinite amount of times per second depending on the number and power of nodes on the Lightning Network.
Transactions on the Bitcoin blockchain are pseudonymous, but there are a variety of firms who make money by snooping around the blockchain and tying real world identities to Bitcoin addresses. Since individual transactions within a Lightning Network payment channel are not broadcast to the Bitcoin blockchain, those details are private and known only to the participants.
Blocks on the Bitcoin blockchain take ten minutes on average to be confirmed, and transactions are widely regarded as irreversible after six block confirmations. Transactions on the Lightning Network by comparison do not require block confirmations and can be executed nearly instantaneously.
Fees paid to nodes on the Lightning Network are often non-existent or commonly denominated in millisatoshis (msats), which are even smaller units than satoshis, the smallest unit of Bitcoin on the layer-1 blockchain. Because fees on the Lightning Network are so small, micropayments of even a single satoshi can be sent between transacting parties.
Lightning In a Bottle
The Lightning Network and other innovations like it make using Bitcoin as a medium of exchange a reality, which is one of the key requirements of any money. The more usable Bitcoin becomes, the more users will gravitate to it over inferior forms of money like fiat currency and precious metals. Bitcoin will continue its march to monetary supremacy.
Crypto Roundup 🤠
Institutional Investment: Hedge funds are beginning to take the dive into cryptocurrency investing and expect to accelerate investment in the space throughout the rest of the year. Read more
Crypto Accessibility: El Salvador’s congress approves a $150 million fund to facilitate conversions between Bitcoin and the U.S. dollar as the country prepares to make Bitcoin legal tend next week. Read more
Government Regulation: Banks in India are finally beginning to relax restrictions against servicing cryptocurrency users after the Supreme Court struck down negative regulation from the Reserve Bank of India. Read more
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Bitcoin has many of the same attributes that has made gold appealing to investors for millennia. On top of that it’s more portable, easier to protect, and can easily be verified from anywhere thanks to blockchain.
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This is not financial advice. This newsletter and related content are for informational purposes only. Cryptocurrencies, stocks, and similar assets can be risky. Always do your own research before making any sort of investment.