July 09, 2020 |James Messi
What is the lightning network?
The lightning network is a second-layer digital ledger that aims to enable the Bitcoin blockchain to achieve scalability without directly affecting the code or programmatic rules on the Bitcoin protocol.
What problems does it aim to solve?
Bitcoin, at its original form, was not capable of handling large amounts of transactions. Blocks happen once every ten minutes on average and if you don’t pay a high enough fee it can take hours or even days for your transaction to go through. This makes microtransactions infeasible, not to mention the fees attached. In order for Bitcoin to be a reputable alternative to fiat currency, it must be able to handle large amounts of transactions. VISA can handle as much as 65,000 transactions per second. Bitcoin at its original capacity could only handle roughly 7 transactions per second. Quickly it becomes clear exactly how much change is needed to make Bitcoin a viable alternative means of payment among other things.
So the solution was designed in 2015 to overcome the scalability problem inherent in Bitcoin.
How it works
The lightning network operates as a layer on top of the blockchain. This makes it so that transactions can be recorded without having the be individually stamped on the blockchain, instead of providing ‘off-chain’ solutions.
Payment channels are the founding structure for the lightning network. To transact with a colleague or business, one would need to open an off-chain payment channel. From then on, the payment channel remains open and any number of transactions can happen between the two parties without payments touching the blockchain. Funds can be moved as quickly as a wallet can communicate. To conclude business, the two parties do a closing transaction on the blockchain and settle debts.
Think of the transactions off the chain as an IOU. The money doesn’t change hands until the blockchain is stamped at the closing transaction. In order to open a payment channel, both parties are required to put what is basically a deposit into the blockchain to form the first transaction. This deposit has to be equal or higher than the amount that will eventually be transacted.
For example, If you’re buying a series of groceries from the store. You’d start with both parties depositing an amount of bitcoin into the blockchain (Layer 1) and then the remainder of your transactions will be recorded on the lightning network off-chain solution (layer 2). It acts like a signed ledger and keeps records of the number of small transactions that have taken place. At any point, either party can back out, which triggers the ledger to be sent to the blockchain and registered there. This would turn potentially hundreds of transactions into just two. Trying to commit fraud and back out of the transaction can lose your entire deposit. This acts as a great incentive to not commit fraud.
It would however seem improbable that you’d like to deposit amounts with every person that you wish to interact with. An inability to put down these deposits will stop payment channels from being opened. To counter this problem, you can use the network of your existing contacts to essentially pay through them. In short, all that is needed to enable an off-chain solution payment between two parties is for there to be a chain of payment channels somehow linking them even if it’s through thousands of different people. This network ability makes the lightning network a true globally scalable payment solution.
How Viable is the lightning network?
There’s a strong argument to suggest that the lightning network doesn’t scale as well as theorized.
1. Strength of individual nodes
Your ability to take part in the network depends on the strength of your node. Networks can change quickly and payment channels can be created and closed extremely quickly. Your node has to identify and pick an optimal path that of networks and then carry out the transaction. It has to do all this work from scratch. Eventually, the network of possible connections would be too vast for the hardware to optimize all the transactions.
2. Liquidity issues
Routing through payment channels seems like a perfect fix to the problem of scalability. However, quickly a number of problems arise that question the suitability of the network. Each payment channel has to be prepaid with a sufficient deposit to cover the transactions that are attempting to be passed through those networks. For example, if 0.2 BTC was needed to pass through a number of payment channels to get to its recipient, each channel must be filled with a deposit of at least 0.2 BTC as well. This works well for small transactions but isn’t feasible for larger ones. In essence, the larger the transaction, the higher the chance that payment channels will not be prefunded to sufficient levels.
In response to these two problems, a number of nodes are can be up with enough liquidity and network connections to limit the number of payment channels needed. They also reduce fees at the same time. These are likely to be set up by large institutions with the ability to overcome economies of scale.
The problem with these nodes is that they’ll likely be classed as third party financial institutions in the eyes of some legal jurisdictions. This could lead to taxes, regulations, and a number of other things that go against the founding principles of Bitcoin. If regulations and excessive documentation do occur this could seriously affect a large chunk of the network and lead to confusion as to the outcome of the off-chain payments. This possibility casts doubt into the viability of the network. However, the network could get to a stage where it’s so intricate that no single country could affect the network by effectively taking the nodes down.
In conclusion, it seems clear that the Lightning network is a viable solution to Bitcoin’s scalability problems so long as you don’t predict large scale node persecution by legal authorities as a possibility in the near future.