When Lightning Strikes Bitcoin
- Bitcoin has an achilles tendon, that impedes it from being a reliable medium of payment.
- The Bitcoin Network can only process about 7 transactions per second (TPS).
- The Lightning Network, a layer-2 payments solution, could be the way to solve this fundamental issue of scalability.
- It is a decentralised network that uses smart contracts to enable instant payments.
Bitcoin’s Problems with Scalability
The birth of Bitcoin in 2009 may be one of the best things to happen to mankind since the internet. A currency that started off with almost no value, grew exponentially, amid speculation, and became the third-largest currency in the world by market cap. Despite this success, Bitcoin has fundamental issues that stand in the way of it becoming the currency of the world. One such issue is scalability. When Bitcoin was announced back in 2008, experts like James Donald were quick to point out the issue of scalability. A decade later and scalability is still a problem.
Since Bitcoin is a distributed public ledger, every node in the network must record every transaction within the network. Given that the Bitcoin Network can only process ~7 transactions per second, significant delays can occur in the network when traffic is high. In comparison, fiat payment solutions such as VISA are capable of processing 1700 transactions per second with peak speeds of up to 5000. To put this in perspective, in a world where instant messaging is the norm, Bitcoin seems to be stuck in the postcard era. With its current infrastructure, Bitcoin is simply not in a position to replace the traditional payment systems where millions of transactions are processed each day.
In recent years, we have seen the emergence of several alternative blockchain networks with native coins affectionately known as altcoins in the crypto community. Some of them have promising technology to tackle the issue of scaling, however none of them seem to have caught on in the same way as Bitcoin. As such, these altcoins lack the “trust factor” that Bitcoin possesses. Bitcoin, with its dominance, still holds the key to making cryptocurrencies mainstream and for this very reason, celebrities such as Jack Dorsey and Jay-Z have invested over 500 BTC for the development of this technology in Africa and India. For Bitcoin to truly be the future standard of payment, it needs a feasible scaling solution and the Lightning Network, well, may just “light” up Bitcoin.
Enter The Lightning Network
First developed by Joseph Poon and Thaddeus Dryja in 2015, the Lightning Network is a layer-2 utility payments solution for Bitcoin and similar blockchains. For the uninitiated, a layer-2 solution is a framework, or protocol, that runs on top of an existing blockchain and enhances it. The lightning network is not a separate blockchain, but a unique solution that can be integrated into existing blockchains to make them better. The principle behind this innovative project is quite simple - If only two participants are looking to engage in a transaction, there is no need for everyone in the network to know about or approve the transaction.
Let’s dial it back a notch. Imagine using a spreadsheet to record your financial transactions on a daily basis. You reconcile this spreadsheet at the end of the month and mark it as your final monthly statement. On the fifth day of the month, your friend asks you if she could borrow $500 and promises to return it on the 15th of the same month. To simplify your bookkeeping (minimize the number of line items recorded), you lend her the money, but do not record this transaction on your spreadsheet. You both sign a contract when she puts in some collateral for the amount borrowed. On the 15th of the month, she promptly returns the $500 and takes back the collateral. This side transaction is complete and you go about reconciling your spreadsheet as you normally do, without overburdening it with unnecessary line items (transactions). In the same way, the Lightning Network allows two users to create private bi-directional payment channels between themselves to send and receive payments without the involvement of the entire network. This means that the transactions between these two users occur almost instantaneously, irrespective of how busy the network is.
The use of these bi-directional payment channels can take Bitcoin from a mere seven transactions per second to millions of transactions per second - a true jump to lightning speed. This will save users hundreds of hours of processing time as well as transaction fees.
Creating a Web of Payment Channels
To implement this ambitious vision of bi-directional payment channels, the Lightning Network makes use of a set of smart contracts combined with multi-signature scripts. Using our example of two friends, A and B, who frequently send and receive payments from each other, they can create a payment channel for themselves on the Lightning Network. To do this, they are first required to create a wallet called the multi-signature wallet, that can be accessed by both parties using their respective private keys, and then deposit a certain amount of Bitcoin into that wallet.
Both A and B start by making a deposit of 5 BTC into their respective wallets. If A would like to send 2 BTC to B, both A and B are required to use their private keys to sign a balance sheet. The lightning network algorithm then uses this signed balance sheet to determine the direction of the flow of funds. As long as this payment channel is active, A and B can keep making thousands of transactions between themselves. Once the channel is closed, the final balances of A and B are updated on to the Bitcoin mainnet as a single transaction. This means that even though thousands of transactions have taken place between A and B, only the final transaction and balance are sent on to the mainnet, thus significantly reducing the load on the mainnet.
Apart from the established channel that A and B share, if A has a separate open channel with C, and B has a separate channel with D, then C and D would be able to transfer funds between each other, even though there isn't an established channel between them. In the same manner, A, B, C and D would all be able to send and receive payments to and from each other. This creates an interconnected web of payment channels. Also, as the Lightning Network continues to grow, the need to create a whole new channel reduces. The algorithm will find the shortest route to transfer funds between users by using this interconnected web of channels.
Advantages of the Lightning Network
The evolution of the Lightning Network, with its layer-2 payment channels, could prove extremely beneficial for Bitcoin and the crypto industry as a whole.
Scalability: By letting users make unlimited transactions off-chain, the network does not just provide a fool-proof solution to the problem of scalability.It also takes them to a throughput level where they can compete with, and even surpass, the most popular fiat payment solutions.
Instant Payments: The evolution of the Lightning Network also means that we can finally bypass centralized payment solutions that have hundreds of middlemen and sometimes take up to three days for cross-border payments. The bi-directional payment channels facilitate unlimited, peer-to-peer transactions that are processed at lightning speed.
Cross-chain Atomic Swaps: While the Lightning Network is still in its early stages of development, it has been adopted by other blockchain networks like Litecoin. If the network continues to grow and evolve as intended, it could be adopted by more and more blockchain networks enabling users to make cross-chain payments. This feature has already been tested and cross-chain swaps between Bitcoin and Litecoin proved successful.
Causes of Concern
The Lightning Network is still in its infancy and comes with its own set of risks. Experts and early users of the platform have been quick to point out some concerns.
Security: As a layer-2 solution, security is always a cause of concern for users of the Lightning Network. Transactions on the Lightning Network are not cryptographically protected as they are on the mainnet. Additionally, the network nodes are required to be online all the time, thus making them susceptible to hacks and thefts.
Malicious Acts: The Lightning Network takes the pseudonymity of blockchains to a whole new level. As most of the transactions take place via payment channels outside the blockchain, these transactions are almost impossible to trace. This makes them an attractive means for malicious actors to transfer funds.
Fraudulent Channel Closures: Even though it requires two users to create a channel on the Lightning Network, channel closure can be done by any one of the users. This means that if two users open a channel and one of them has malicious intent, they can easily steal funds from the other. Consider a case in which A bought 1 BTC worth of goods from B. If B is offline, A can close the channel and broadcast the initial state onto the mainnet. This will be as if a transaction had never happened between them. A just got 1 BTC worth of goods for free.
It is worth noting that, even though these problems exist now, the developmental team of the Lightning Network has been working on feasible solutions like Watch Towers, to monitor malicious acts. As the network continues to evolve, these causes of concern are likely to be hashed out.
Nothing in this article constitutes professional and/or financial advice. The content is provided exclusively for informational and/or educational purposes. Nothing is to be construed as an offer or a recommendation to buy or sell any type of asset. Seek independent professional advice in regards to financial, tax, legal and other matters.