When the first digital currencies were being developed in the late 2000s, the blockchain technology powering those early-day cryptos wasn't designed with widespread adoption in mind. Fast forward to today, flagship cryptos like Bitcoin and Ethereum, each with millions of users, struggle with scalability issues.

In Bitcoin's case, one answer is a new second layer blockchain upgrade called the Lightning Network. There is a lot of excitement surrounding this tech, with some calling it a "game-changer" for Bitcoin. Here's what you need to know about the Lightning Network, how it works, and why it is so important.

What Is The Lightning Network?

The Lightning Network is a layer-2 blockchain project that's designed to add a new level of transactional functionality to the Bitcoin network. It allows two parties to create a peer-to-peer payment channel where transactions can take place away from the main blockchain. This is also known as off-chain transactions.^[1]

Off-chain transactions let parties sidestep the typical congestion seen on the Bitcoin mainnet. Once both parties finish, the net results of these off-chain transactions are then combined and transcribed onto the Bitcoin blockchain as a single, bigger transaction.^[1]

Where Did The Lightning Network Come From?

The Bitcoin Lightning Network was initially developed in 2015 by Thaddeus Dryja, a research scientist at MIT, and Joseph Poon, a blockchain scalability researcher. The duo co-authored the Lightning Network whitepaper in 2016. They later founded Lightning Labs, an entity focused on devising new ways to help solve scalability problems.^[2]

Even before the Lightning Network whitepaper, the crypto community was well aware of the limitations of Bitcoin transaction speeds. In fact, legendary Bitcoin founder Satoshi Nakamoto flirted with something akin to a proto-Lightning Network of sorts, as well as a system of off-chain payment channels.^[2]

Why Bitcoin Needs The Lightning Network

On the Bitcoin blockchain, each block contains a limited number of transactions. If your transaction can't make it onto the current block, it joins a queue to be transcribed onto the next one. This queue can take anywhere from a few minutes to a few days or more to process.

This is the main problem behind Bitcoin scalability, and it's one reason why using Bitcoin in day-to-day transactions will never be widespread. It's impossible to buy a cup of coffee or pay for your groceries in Bitcoin if it takes hours or more for a transaction to go through. That's why Bitcoin turned into more of a form of "digital gold," as it's functionally quite impractical for micropayments and day-to-day use cases.^[1]

How Does the Lightning Network Work?

Lightning Network is a layer-2 solution built on top of the Bitcoin network, meaning it's a separate entity that directly interfaces with Bitcoin. It works by enabling numerous peer-to-peer payment channels, each of which is strictly between two parties transacting in BTC.^[3]

Each payment channel acts as a kind of ledger, keeping a record of transactions between two parties until the channel closes. To create a channel, one payer must first lock in a certain amount of Bitcoin. Then the party that wants to receive payment creates an invoice in the form of a special QR code, while the party making the payment scans said QR code with their lightning wallet.^[4]

Two parties can transfer Bitcoin indefinitely without needing to tell the main blockchain. Only once both parties decide to finish transacting can they close the channel. Once that's done, the net result of the entire channel history is recorded as a single transaction, which is then transcribed onto the Bitcoin mainnet.^[4]

This consolidation process allows dozens or hundreds of transactions to be packaged together into a single, on-chain transaction. This makes the Lightning Network substantially more useful for real-life, day-to-day expenditures, as it means you can make small, day-to-day transactions with instant payments, which you can't do on the Bitcoin mainnet.

What Are Nodes?

A Lightning node is a piece of software that connects and interacts with the main Bitcoin blockchain network. In a way, it's the intermediary point between Lightning and Bitcoin. Nodes are also involved in verifying transactions that users of a said node are involved with. Any dedicated user can also become a node and earn network fees in the process.^[4]

What are the Lightning Network Fees?

The Lightning Network charges incredibly small fees, with a base fee per transaction of 1 Satoshi (or 0.00000001 BTC), roughly the equivalent of US$0.04. Lightning Network can also process a million transactions per second, effectively ensuring fees remain close to non-existent.^[5]

In contrast, the main Bitcoin blockchain can process around seven transactions per second. It's one reason why the channels on the Lightning Network enable close-to-instant transactions between parties.

Pros Of Lightning Network

The advantages of the Lightning Network are self-evident and, once applied to Bitcoin, could prove game-changing for the cryptocurrency.

1. Speed (Transactions per Second)

In theory, the Lightning Network would drastically increase the total transactional bandwidth available to the Bitcoin ecosystem, with faster transaction speeds being a byproduct.^[5]
By sidestepping the Bitcoin blockchain altogether via off-chain transactions, individuals can transfer bitcoin between each other with near-instant transaction times.

2. Privacy

While still not nearly as private and anonymous as Monero, the Lightning Network is more private than using the Bitcoin mainnet (especially as a sender of BTC). That's because transactions are only transcribed onto the blockchain after the payment channels close.^[6]

While governments eager to constrain cryptocurrency often say criminals use it for anonymity, the Bitcoin blockchain is quite the opposite. As a public ledger, anyone can see any transaction they like and which wallets were involved in said transaction.

Lightning Network is more private than just going directly to the Bitcoin blockchain, as individual off-chain transactions aren't recorded onto the mainnet. They simply get condensed into a larger transaction void of any private details.

3. Transaction Costs

Another benefit to the Lightning Network is lower transaction fees. In the normal Bitcoin blockchain, transactions with higher fees are prioritised by miners, meaning that during periods of congestion, you'll have to pay more in order to get your transactions processed in a reasonable time. With Lightning, you could simply open up a channel between another party and send bitcoin however you wish. ^[5]

Cons Of Lightning Network

While the Lightning Network is a powerful solution to Bitcoin's main problems, it's not perfect either.

1. Erosion Of Incentives

While the Lightning Network can lower fees, that might not necessarily be good for the blockchain. As a decentralised network, Bitcoin functions not because of a central entity but because numerous people voluntarily chose to participate as miners and validators in exchange for mining rewards.^[7]

If the Lightning Network lowers fees, that also discourages people from verifying transactions as their incentive rewards will decrease. Additionally, nodes on the lightning network might not receive enough payments or fees even to encourage people to become nodes in the first place.
The counter-argument is that the total volume of transactions should drastically increase, as day-to-day Bitcoin purchases weren't a realistic possibility prior to the Lightning Network. So in principle, larger volumes and liquidity should even out lower fees per transaction, but that has yet to be seen.

2. Transaction Risks And Security

In the lightning network, two parties in a payment channel can take advantage of one another. This usually involves one party closing the channel and pocketing funds without providing said service, or resetting the channel to when it was first opened. This then allows the person who bought goods or services to get away without having paid anything, an issue referred to as a Fraudulent channel close.^[12]

The good news is that there's a period in which someone can contest a channel's closure. However, this period will expire if one party is gone for a prolonged period.

Another security risk is malicious attacks on the Lightning Network. According to Dryja, "forced expiration of many transactions may be the greatest systemic risk when using the Lightning Network."^[8]

Hypothetically, let's say that the congestion levels become especially challenging, especially from a malicious attack of some kind. In that case, the payment channels could become so congested that participants may not be able to get their money back enough due to congestion.

3. Reliance On Bitcoin

The Lightning Network is largely tied in with the future of Bitcoin. If another cryptocurrency takes its place, the lightning network will lose most of its utility until other tokens are linked up to it.

The Lightning Network also assumes Bitcoin will have a lot more demand from people interested in using it as a means of daily exchange. However, that's far from certain. Bitcoin has established itself as a kind of digital gold, but its price volatility may discourage people from using it frequently. Its volatility also makes it difficult for companies to use Bitcoin as a payment method when pricing their goods or services.

Summary

The Lightning Network has the potential to be the next big revolution for Bitcoin, and its drastic growth in 2022 is a testament to that.

Users with access to Lightning payments grew from 100,000 in the summer of 2021 to more than 80 million in March 2022. Additionally, Lightning Labs plans to expand Lightning's potential by allowing users to trade other types of tokens. In particular, one protocol would allow users to trade stablecoins on Bitcoin and Lightning instead of just BTC.^[9]

Many cryptocurrency exchanges are adding lightning network transaction support. Bitfinex was one of the first in 2019, with others like Kraken joining as well.^[10] Twitter co-founder and former CEO Jack Dorsey also hinted that he aims to integrate micro-bitcoin payments via the Lightning Network onto his own payment platforms.^[11]