When Bitcoin creator Satoshi Nakamoto introduced the Bitcoin white paper in the fall of 2008, he wrote,
“I’ve been working on a new electronic cash system that’s fully PeerToPeer with no trusted third party.”
Firstly reply to that message was enthusiastic, but there was much doubt about the project’s scalability, that BTC could be mass adopted.
Though there have been many attempts to tackle Bitcoin scalability issues, only one implementation has stood the test of time.
What is the Lightning Network?
This scaling solution is called the Lightning Network, and over the last year, it has seen a surge in adoption from individuals, businesses, and even governments for fast and fearless BTC payments.
What You will know about the Lightning Network?
Will the Lightning network lead to the mass adoption of Bitcoin?
Let’s dive into Bitcoin’s leading layer two to understand what the Lightning network is, how it works and why it’s essential to be familiar with a few Bitcoin basics.
BTC as peer to peer electronic cash system
Bitcoin was designed to be a peer-to-peer electronic cash system. As per the Bitcoin white paper title, Bitcoin is the Payment System or Network, whereas BTC is the electronic cach itself. Unfortunately, as highlighted by the first reply to Bitcoin creator Satoshi Nakamoto, the Bitcoin network is unable to scale enough to make it possible for everyone on the planet to use BTC as a payment method.
Now, scaling is just a technical term for speed.
The Bitcoin network can only handle around seven transactions per second, or TPS for short. By contrast, Visa handles around 1700 TPS on any given day, and it can scale up to 650 TPS if need be.
Visa’s upper TPS limit has Consequently become the benchmark for optimal speed in cryptocurrency. There’s only one that has achieved this degree of scalability.
Bitcoin is nowhere close to this benchmark, and this is because of its block size and block time. A Bitcoin network is a blockchain, just a distributed record of transactions shared by all computers connected to the network.
These transactions are batched into blocks. Hence the word blockchain. Each Bitcoin block is only 1 MB large, and because each BTC transaction has a digital size, only 2700 or so can fit in each Bitcoin block.
This limited space is why there are transaction fees to incentivize the computers—verifying BTC transactions called miners to include a BTC transaction in the next block. You get about seven transactions per second when you divide that number by Bitcoin’s block creation time of roughly ten minutes.
Given these facts, you might think that the simple solution to the Bitcoin scalability problem is to increase the block size, block time, or both.
This is actually what many Bitcoin Forks have done or tried to do. The only problem there is that doing any of those would compromise the security of the Bitcoin network. Now, this is why Satoshi designed Bitcoin the way he did. If the block size is too large, eventually, only a handful of computers will be able to store the entire history of BTC transactions because it would be too large for most of them to handle.
If the block time is too fast, it limits the number of computers that can verify transactions on time, and if there are too many, you’d quickly end up with conflicting BTC transaction histories.
This means there is only one solution left, and that’s to somehow process BTC transactions outside of the Bitcoin network or off-chain at a faster speed without compromising security or increasing costs.
Lightning network – the beginnings
This is where the Lightning Network comes in. The Lightning Network has its roots in Satoshi Nakamoto’s earliest writings, but its creation is credited to two brilliant developers, Fadeus Dryer and Joseph Poon. Fideus is a longtime Bitcoin developer and currently works at MIT’s Digital Currency Initiative, focusing on cryptocurrency scaling and interoperability.
Joseph Pune is a longtime Bitcoin developer and shifted his focus to Ethereum in 2017 when he coauthored the Plasma white paper with Ethereum founder Vitalik. Buterin.
Plasma is a popular Ethereum scaling solution leveraged by crypto projects such as Polygon. Hydes and Joseph began brainstorming ideas about scaling Bitcoin in 2014 after seeing how inefficient some of the other scaling solutions were.
The pair first penned the Lightning Network white paper in February 2015 and subsequently presented their invention at an annual Bitcoin conference in San Francisco.
In January 2016, the duo founded Lightning Labs and two other Bitcoin enthusiasts to develop the Lightning Network.
The Lightning Network was completed in February 2018. This occasion was marked by the purchase of two pizzas using BTC enlightening by Laszlo Hanneex.
If this scenario sounds familiar, it’s because Laszlo is the man who made the first-ever purchase with Bitcoins in May 2010 when he bought two pizzas for 10,000 BTC $461,650,000 at current prices.
In March 2018, Lightning Labs received over 2.5 $ million in funding from prolific investors, including Twitter CEO Jack Dorsey.
A few days later, the Lightning Network was deemed ready for regular Bitcoin users. The Lightning Network has seen some severe adoption since then. For example, El Salvador is the first country to use the Lightning Network for BTC payments.
How Lightning Network works?
Unlike most layer two networks for cryptocurrency, the Lightning Network is not a blockchain. Instead, it consists of a series of interconnected payment channels created by two parties on the Bitcoin network.
Imagine there’s a restaurant you go to every day because you’ve become such good friends with the owner of the restaurant.
He doesn’t always make you pay at the end of every meal.
Better yet, he gives you discounts or even free food for helping out around the restaurant or just being a good and loyal customer. The restaurant owner keeps a record of how much money you owe him for meals minus the ones you got pro-bono for helping out and only asks you to pay up at the end of each month when the restaurant’s bills are due.
This payment record you have with the restaurant owner is not all that different from the payment channels you find on the Lightning Network.
To understand how-to, let’s imagine you and the restaurant owner agreed to settle your monthly tab in BTC, and you’ve decided to use the Lightning Network.
This means you’ll have to create a payment channel on the Bitcoin blockchain.
This involves a multi-signature wallet. As the name suggests, a multi-signature wallet is a cryptocurrency wallet, which will only send out a transaction if the signatories agree.
In our example, that’s you and the restaurant owner. First, you both deposit an amount of BTC into the multi-signature wallet. For security reasons, this amount must be worth the same or more than what you expect to transact next month.
This transaction on the Bitcoin blockchain creates a payment channel that allows you to transact the BTC you deposited between each other instantly as many times as you want for next to nothing.
This is because what you’re sending between each other is not actually BTC, but a digital IOU of payments like the physical IOU record you are using for regular money.
Put differently. You’re just adjusting how much of the BTC in the multi-signature wallet address each of you will get when the payment channel is closed. This record is updated every time a BTC transaction is made in your shared payment channel, and this record is kept on both of your computers.
It might help to think of it as a sort of receipt.
Whereas regular BTC transactions require at least one block to be generated and can cost upwards of $50 to push through because you’re just passing around an updated receipt between two computers, the only limiting factors are computer hardware and Internet speed.
This makes transactions on the Lightning network lightning fast, with tens of thousands of transactions per second for every connected computer. When the month is over, the BTC in the multi-signature wallet is sent back to each of your own BTC wallet addresses based on the balance of the final digital IOU receipts on both of your computers.
This creates a second transaction on the Bitcoin blockchain and closes the payment channel. Note that a payment channel can be kept open indefinitely and can be closed at any time by one or both parties.
It turns out that if you didn’t pay what you owed, the BTC you put into that multi-signature wallet would automatically be sent to the restaurant owner if he overcharges you; the opposite occurs.
Although this probably won’t happen because you and the restaurant owner trust each other, this trust isn’t always there when you’re transacting with strangers, which is why both parties always have to prefund the multisig wallet with some collateral to incentivize good behavior.
It leads to the interconnectedness of the payment channels, making the Lightning Network a global network and not just a two-way street between two people.
Here’s how that works. First, suppose there’s another regular at the restaurant.
Let’s call him Mad Mike now; Mad Mike has a BTC payment channel open with the restaurant owner as well. He even has a BTC payment channel open with your Barber. So now, when you see Mad Mike’s fresh-cut, you realize you forgot to leave your Barber a tip.
You’d like to pay this tip with BTC the last time you were there, but you don’t have a payment channel open with the Barber. Luckily, the Lightning network has got you covered.
Instead of having to ring up your Barber and set up a payment channel with him directly, your BTC tip can make it to his wallet via the payment channels that connect you, you and the restaurant owner, the restaurant owner, and Mad Mike and Mad Mike and the Barber.
Suppose you happen to have a payment channel open with Mad Mike. In that case, the Lightning Network will automatically route your BTC tip through him to minimize the distance it needs to travel in the same way that real Lightning finds its way to the ground based on the path of least resistance in the atmosphere.
You might be worried, though, that Mad Mike might try and steal that BTC tip in transit since he’s a shady fellow. But the Lightning network has got you covered there too. BTC payments made through intermediary payment channels are secured by a technology called Hashed Timelocks.
This involves exchanging a secret code with the end recipient first before any BTC is sent. Once that secret is successfully exchanged, the corresponding amount of BTC is transferred.
If anything goes wrong along the way, such as one of the connected computers going offline, the transaction is automatically canceled. The appropriate parties are punished if it was a malicious act; the more payment channels, the faster and more farreaching the Lightning Network is. This connectivity means it’s possible for the whole planet to use BTC as a digital cache like Satoshi envisioned.
To further facilitate the growth of the Lightning network, It was designed such that it’s possible to create more than one version.
Lightning network for other Crypto
This means that anyone can create their own custom version of the Lightning Network. And thanks to something called the Bolt protocol, all versions of the Lightning network are interoperable.
To top it all off, the Lightning network can be used with any cryptocurrency which supports multi-signature wallets and hashed timelocks, which is almost all of them.
Because the Lightning Networks interoperability features are not limited to any one blockchain, this means you can instantly trade supported cryptocurrencies between blockchains at near-zero costs without a cryptocurrency exchange.
With all these crazy features, it should come as no surprise that the Lightning Network has grown exponentially over the last year.
Over 60,000 Lightning Network payment channels worldwide, with over $100 million in BTC locked in its multi-sig. While actual user adoption of the Lightning Network had a slow start, the pace picked up at the start of 2020 when Bitcoin Lightning Wallet developer Zap released the now-famous Strike app.
Zap Solutions is the company that helped the government of El Salvador make BTC legal tender. This was after the President took notice of Strike’s popularity in the country thanks to its fellow’s remittance payments powered by the Lightning Network.
When El Salvador’s legal tender law goes into effect at the beginning of September, we could see millions of people transacting BTC on the Lightning network. Now less than one month after Strike’s 2020 launch, Lightning Labs announced that it had raised another $10 million from a handful of heavyweight investors.
Shortly after that, Lightning Labs released an update to its Lightning implementation that increased the amount of BTC that could be sent through payment channels. This paved the way for more Lightning network adoption by more significant players in the crypto space, including cryptocurrency exchanges.
Crypto exchanges implement the Lightning Network
Late last year, Kraken announced that it would add support for the Lightning Network in February. Okx added support for the Lightning network. A few days later, PeerToPeer cryptocurrency Exchange Paxful announced they had done the same.
In March, a crypto startup called Moon made it possible to pay with BTC using Lightning online with any merchant that accepts Visa.
In May, Tesla CEO Elon Musk took a break from Bashing Bitcoin to praise the potential of the Lightning network. In June, Twitter CEO Jack Dorsey said he plans on adding the Lightning Network to Twitter and its decentralized counterpart, Blue Sky.
In June, a Canadian company called Liquid Fintech Corp. became the first publicly-traded company whose sole purpose is to develop Lightning Network infrastructure.
More recently, a Las Vegas strip club announced it had begun accepting Lightning Network BTC payments. Speaking of use cases, Bitcoin evangelist Andreas Antonopoulos believes that it’s only a matter of time before the Lightning network is used as a quote stream of money.
For example, instead of getting paid weekly or monthly, you could be paid by the hour or even by the minute, thanks to the speed and low cost of the Lightning Network.
Instead of paying monthly or yearly for a Netflix or Spotify subscription, you could pay for each minute of content you consume on their platforms instead. And it’s not just payments where the Lightning network can be used either. For example, some crypto companies such as Zebedee have combined BTC with video games, making it possible for gamers to earn SATS by playing.
Issues of the Lightning Network
The Lightning Network has had its fair share of issues, and not all of these have been resolved. Dozens of code vulnerabilities have been found since the network launched in 2018, so much so that many still consider it to be in its testing stages, even though it’s technically fully operational.
That said, the Lightning network’s biggest problems are not technical. They’re structural. For starters, depositing BTC into a multi-sig wallet to create a payment channel makes BTC much harder to sell since it often needs to be transferred to the Bitcoin blockchain before being exchanged for Fiat.
Over time, this is becoming less of an issue as more Fiat payment pathways like exchanges integrate the Lightning network. However, it’s still something that’s not readily available to the average BTC holder.
If the price of BTC were to pump or dump too much, you could see a lot of payment channels close as multi-sig participants sell their BTC because of profit or panic. This could shrink the size of the Lightning network and possibly even cut off some BTC holders on Lightning from off-ramps that accept BTC via Lightning.
Not only that but there are not many incentives to keep a payment channel open to begin with. Fees on the Lightning network rarely exceed a handful of Satoshi’s worth fractions of a Penny. These are paid to any intermediaries when BTC moves between payment channels.
The Lightning Network for an average user
The average user is unlikely to keep their BTC locked up on the Lightning network for pennies in profit. For the average user, the value of the Lightning network comes from its utility. Moreover, when you send a BTC transaction across multiple payment channels on the Lightning network, every single one of the multi-sig wallets on the way must have a BTC balance larger than or equal to the amount being sent.
The Lightning Network decentralization
This makes larger transactions harder to do. When you combine these pain points with the cost of opening and closing payment channels on the Bitcoin blockchain, you end up with a Lightning Network that is remarkably centralized, with most traffic taking place through custodial intermediaries that are not that much different from banks.
This has historically been one of the biggest criticisms of the Lightning network, but this has also been improving as time goes on.
So this begs the question, if operating a payment channel on the Lightning network is not very profitable, then where does the incentive come from for the individuals and institutions providing this service?
You can often hear, “when a product is for free, you are the product.”
In the case of the Lightning network, likely, most of the companies operating Custodial Lightning Wallets and services are closely tracking their user’s transactions.
It’s even possible that this tracking is happening on the Lightning network itself through watchtower nodes, which analyze payment channels for any fraudulent transactions and notify any affected users so they can close their payment channel and claim their BTC.
This sort of surveillance may not be very profitable today. However, it will become more profitable as the adoption of the Lightning network continues. Big businesses will want to see where all the little people are spending their money in real-time and will gladly spend some of their own to get this information.
This concern runs contrary to the Lightning Network’s supposedly superior Privacy.
The Lightning Network has been on the radar of US regulators since last summer when the IRS published a document that cited the rapid growth of the network as a cause for concern. Although the document notes that Lightning Labs has developed a tool to track transactions on the Lightning network, it can only be used by someone operating a payment channel and only for their own payment channel.
In other words, the only transactions they can track are the ones they are making with the other party in their payment channel.
They can’t track the transactions they are rooting on behalf of someone else. Now, this has to do with the hashed timelock technology.
Recall that this involves exchanging a secret code between the sender and the recipient before a transaction is made. When this transaction hops through all the payment channels, the participants in between have no idea where that payment came from, where it’s going or what their position is in the transaction’s path.
So to use our restaurant example, if I send the BTC tip to my Barber through the restaurant owner and Mad Mike, neither of the two knows which position they’re in when that payment goes through, nor do they know whom it came from or whom it’s going to.
Now, this is, of course, easy to figure out when you’re dealing with a small group of people. But as the Lightning network grows, it gets harder and harder to trace transactions. Besides stuff like Watchtowers, the most significant vulnerability of the Lightning Network’s privacy has to do with the transactions made on the Bitcoin blockchain, when payment channels are opened and closed with multi-sig wallets.
These transactions look different from regular transactions, making them much more accessible for government-friendly blockchain tracking firms such as Chain Analysis to trace.
As it so happens, Bitcoin’s upcoming Tat route upgrade will make multi-sig wallet transactions look identical to regular transactions.
Speed, privacy, and cheap combine?
After November, there will be no telling when someone is moving their BTC on or off the Lightning Network. So what that means is that Bitcoin could offer Manerolike Privacy with Visa level speed at near-zero fees, thanks to the Lightning Network.
If the Lightning Network sees a similar degree of adoption on other popular cryptocurrency blockchains, this could usher in the cypherpunk future that Satoshi and so many others envisioned.
It might just save cryptocurrency from the incoming regulatory crackdown, too.