What is Lightning Network and how does it work?
Bitcoin is the world’s first cryptocurrency. It allows you to do transactions across the globe openly and transparently. It also removes the need for intermediaries such as banks and puts you in charge of your money. Read more about Bitcoin here.
Bitcoin is great; however, it has some limitations. The main argument why Bitcoin cannot be used as a day-to-day currency for microtransactions is because of its slow network and high transaction fees. The technology that makes Bitcoin great has also created a scaling issue.
Bitcoin’s blockchain needs several computers to verify transactions. This process increases the transaction confirmation time. At present, Bitcoin can handle only seven transactions per second.
This capacity can double with some additional upgrades, but it is still not close to the traditional payment systems. Visa, for example, can process up to 65,000 transactions per second. This volume makes Bitcoin ill-equipped to play a role similar to fiat currencies.
It is where the lightning network comes in.
Lightning network is a layer two payment protocol built on the Bitcoin blockchain. It is developed on top of the Bitcoin network. So, if Bitcoin is layer 1, the Lightning Network can be considered layer 2.
It also enables fast transactions at low costs. In simpler terms, the Lightning Network is a set of rules designed to facilitate micro-payments.
The lightning network was introduced in 2015 by Joseph Poon and Thaddeus Dryja. The main idea behind it is to eliminate the need for recording micro-payments directly on Bitcoin’s blockchain. These payments can instead be recorded on the Lightning Network.
Only the transactions that create the channel and settlement are recorded on-chain (in this case, the Bitcoin blockchain). The Lightning Network creates a secure channel between individuals through which users can quickly and efficiently exchange BTC.
The transactions are much faster because approvals are not required from every node on the blockchain for each transaction.
Let’s understand how a lightning network works.
The lightning network produces a payment channel by creating a multi-signature wallet and adding funds to it. The fund acts as a security deposit for payments. This process helps transfer funds quickly and easily.
For instance, suppose you want to do regular transactions with your friend and pay Bitcoin. You need to open a payment channel and deposit a certain amount of crypto in your wallets. This amount should be equal to or larger than the value you want to transact. It will act as a security deposit.
Let’s say you and your friend both deposited 1 BTC in your wallet. With the creation of the layer two payment protocol, all transactions between you and your friend will be recorded on the Lightning Network.
If you or your friend wants to settle the transaction, it can be done using your signature. The final wallet balance will be recorded on the blockchain.
Even though you have made thousands of transactions between you and your friend on the Lightning Network, it will only display the opening and closing transactions on Bitcoin’s blockchain.
The Anti-cheat Mechanism
Additionally, the Lightning Network has a fraud protection system. Suppose you try to back out or perform any malicious activity for some reason. In that case, the system will penalize you by taking out the amount of BTC in your wallet as a security deposit and send it to your friend.
Such harsh penalty is in place to discourage participants from trying to cheat the system.
The lightning network also allows you to jump through a connected payment channel. It means you don’t have to open a new one when transacting with various individuals.
It finds a path with the other participant in the network, through which you can pay without using the Bitcoin blockchain. It makes the lightning network globally scalable.
Perks of the lightning network
- Due to delayed verification time and high transaction fees, it is impractical to use Bitcoin for day-to-day uses. On the other hand, the lightning network’s low transaction cost and instant payment make it ideal for real-world uses.
- Transaction fees of the lightning network can be as low as one Satoshi, which is the smallest unit of Bitcoin and is equivalent to a fraction of one cent.
- Everyone can use the Lightning Network for smaller payments.
Some downsides of the lightning network
- The Lightning Network is still in its early stages, and it still has a long way before becoming the go-to payment method for daily transactions.
- You need to pay transaction opening and closing fees on Bitcoin’s network, which sometimes can be pretty high.
- The transaction is possible only when all parties that are involved in the transaction are online.
For Bitcoin to become part of day-to-day transactions, it will have to process thousands of transactions per second.
The Lightning Network can help scale Bitcoin and other cryptocurrencies that are becoming mainstream. However, the technology is still in its nascent stages. There’s a long road ahead before Bitcoin can be a preferred payment method.
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