Bitcoin’s Lightning Network Explained Simply

By: Steven Hay | Last updated: 8/23/20

The Lightning Network is a relatively new emerging concept allowing instant, fee-less Bitcoin payments. In this post I’ll cover exactly what this concept is all about and what the future holds for the lightning network.

Lightning Network Summary

While Bitcoin offers a solution to many of the problems presented by our current money system, it still has some drawbacks. One of its biggest limitations concerns the speed and price of transactions, especially during busy times.

Built as a second layer over the bitcoin network, the lightning network enables people to transfer Bitcoin between one another instantly and without any fees. This is made possible by creating payment channels between two users. Payments can also be made between users that are connected indirectly, via network channels.

That’s the lightning network in a nutshell. For a deeper explanation on how it works keep reading, here’s what I’ll cover:

Don’t like to read? Watch the video version of this guide:

1. Bitcoin’s Scalability Issue

Bitcoin is great. It puts you in control of your own money, allows you to connect with people half way across the world and it can’t be shut down by any government or bank. But just like everything else, it has its limitations.

If you’ve ever tried to send a transaction during a particularly busy time, you’ve probably noticed that Bitcoin transactions can get slow and expensive.

Bitcoin transactions are confirmed by miners only once every 10 minutes on average and if you didn’t attach a high enough fee, it can take even days to get confirmed.

Unfortunately, this means Bitcoin, in its current form, isn’t scalable. While Visa can process up to 65,000 transactions per second, Bitcoin can handle only 7 transactions per second. With additional upgrades this number can increase to double digits, but it’s still not even close to traditional payment processors.

This becomes a real issue with day to day micro-transactions. One of the main arguments of why Bitcoin can’t be used as a medium of exchange is due to how slowly it works and how expensive it is to send small payments through the network.

Due to the above, some altcoin advocators argue that this might be a good reason to drop Bitcoin and move to their coin. However, this might not be such a great idea, here’s why:

Some altcoins are scammy and only want your Bitcoin in exchange for their shitcoin (yes, it’s a word). No coin is as widely accepted and trusted as Bitcoin. If their coin ever becomes as popular as Bitcoin, there’s a good chance it’ll run into exactly the same limitations (as can be seen with Ethereum).

Wouldn’t it be great if we could have instant and feeless Bitcoin transactions?

2. What is the Lightning Network

The Lightning Network is a set of rules that are built on top of Bitcoin’s blockchain and are specifically designed to facilitate micropayments. So if Bitcoin is layer one, the Lightning Network is considered a layer two solution.

The concept was originally introduced by Thaddeus Dryja and Joseph Poon back in 2015. These two young developers significantly advanced Satoshi’s original design by proposing a decentralized network of lightning-fast transactions.

This network element is capable of connecting any and all users to this “fast and feeless” system, through a routed series of transactions. In other words, with this solution we can get all the benefits Bitcoin has without its drawbacks.

3. How Does the Lighting Network Work?

The basic concept behind the Lightning Network is payment channels. If I want to transact with my friend, we open an “off-chain” payment channel between us on the Blockchain.

From then on, the payment channel is open, and any number of transactions can directly occur between my friend and I—without payments ever touching the main blockchain.

Thanks to this, funds can be transferred as quickly as the users’ wallets can communicate over the net. Once we want to conclude our business, we conduct a “closing transaction” on the main blockchain, and basically settle all of our previous transactions.

Simply put, my friend and I write down how much each one owes the other without ever exchanging the money until we choose to settle the bill.

However, unlike in the example above, in many cases you won’t be transacting with a friend but rather with someone you don’t know. This brings up the question “how can I trust someone not to run away if he or she owes me money?”

The answer is pretty simple.

When you open a payment channel, each of you deposits a certain amount of money that acts as a security deposit. The amount of this deposit has to be equal to or higher than the value that is transacted.

Example: Small Payments Using Bitcoin’s Blockchain

Let’s say my friend and I want to make some small bets on the results of the world cup. If we pay each of these small bets over Bitcoin’s layer one blockchain, we will end up paying a lot more than we intended, due to fees charged for each transaction.

On the other hand, if we don’t pay enough fees, we might find ourselves waiting for hours for the money to change hands.

Small Payments on the Lightning Network

So my friend and I want to conduct a series of bets with a total value of one Bitcoin. We open up an “off chain” payment channel between us and each of us deposits 0.5 Bitcoins as a security deposit.

Technically, what happens is that we both send an amount of 0.5 BTC over the layer one blockchain to a multi-signature (aka multisig) Bitcoin address. This enables Bitcoin miners to process and confirm the layer one transaction.

This deposit is the only payment that actually “reaches” the layer one blockchain. From now on, the smaller payments will be settled between my friend and I over the lightning network’s payment channel.

Keep in mind that if at any point either one of us wants to back out of the transaction, we can easily just take our deposit and leave without consulting with the other person.

However, such one-sided withdrawal will force the leaving side to wait 1,000 blocks’ confirmations (~1 week) to get the deposited Bitcoins back. The party “left behind” will receive the Bitcoins back instantly.

Now, let’s assume that I lose a bet and need to pay my friend 0.1 Bitcoin. We will both sign a transaction in our “off chain” ledger (kind of like a small pocketbook) stating that I now have 0.4 Bitcoins and he has 0.6 Bitcoins.

If at any point my friend wants to leave with the winnings he can just display our signed ledger to the network and the deposits will be returned according to the new balances. This closing transaction happens on layer one network.

Is the Lightning Network Secure?

The Lightning Network also has a fraud protection mechanism built in. If for some reason I were to try to back out without paying 0.1 and take my whole 0.5 Bitcoins back, the whole deposit (1 Bitcoin) will be sent over to my friend. Such harsh penalties are in place in order to discourage participants from trying to cheat.

Remember, even if my friend and I transacted over 1000 times, the blockchain will only show two transactions – one for opening the payment channel and depositing money and one for closing it and settling the bill. All of the transactions in between were basically feeless and instant.

4. Network Channels

You’re probably thinking: “does this mean that in order to make every day transactions I need to deposit funds with each new person I want to interact with?”

That’s not very realistic.

For Bitcoin to become a true alternative for cash and credit cards, we need to be able to conduct such swift and fee-less payments with complete strangers and without making such deposit every time.

In order to overcome this issue, the Lightning Network allows me to “jump” through connected payment channels. Network channels allow payment channels to connect indirectly, via intermediaries.

If I have a payment channel with my friend, and he has a payment channel with his sister, I can ask my friend to pay his sister on my behalf using their open payment channel. I then pay him back the moment he provides proof he did so.

This network effect makes the Lightning Network much more powerful. Since in order to transact with anyone, you just need to find a path to that someone through other participants in the network who already know each other.

It doesn’t even matter if that channel goes through a hundred different intermediaries, making the Lightning Network globally scalable.

5. Future Possibilities of Lightning Networks

Using the lightning network, all sorts of new payment models will become possible. Just think what a payment system that can reach anyone instantly with no overhead, can do. Much like the effect of audio and video content streaming, we might see an era of streaming money.

For example, your smartphone could use Lightning to make automatic micro-transaction payments to WiFi hotspots that it connects to, enabling you to only pay for the parts of the video you’ve watched.

Or even wilder, think of a world in which instead of getting a monthly paycheck, workers get paid for every second they work. Wouldn’t that be neat?

Here’s a video by Andreas Antonopoulos explaining this idea, along with another very good explanation about the whole system:

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6. Conclusion

Hopefully by now you understand the basic concepts of what the Lighting Network is and how it works. Still feel a little confused? You’re not alone. At the moment, it’s one of the more technical and complex subjects to explain.

There’s still a long way before the Lightning Network finishes its testing phases or becomes fully operational. Still, in light of Bitcoin’s very problematic drawbacks I covered in the beginning of this article, this is really big news.

With instant and fee-less Lightning payments, Bitcoin would finally be able to replace credit cards and even cash, or other person-to-person transaction methods.

Have additional questions about the Lightning Network? Just leave them in the comment section below.