1) What’s going on here?

The transaction fees on the Bitcoin network have skyrocketed to new all-time highs of over $30 in the past couple of months, but a new scaling solution might save the day for the digital currency in 2018.

2) What is the Bitcoin Lightning Network?

The Lightning Network is a proposed system built on top of Bitcoin that would let people instantaneously send/receive payments and reduce transaction fees by keeping them off the main network. It helps Bitcoin be more useful as a day to day currency.

3) How does it work?

The Lightning Network is a system of smart contracts built on top of the base Bitcoin blockchain that allows for fast, cheap payments directly between two parties. In order to achieve these fast and cheap transactions, the following steps are taken:

A multi-signature wallet which holds some amount of bitcoin (provided by at least one of both parties) is set up

The wallet address is then saved to the public Bitcoin blockchain including a balance sheet (smart contract) that proves how much of this bitcoin deposits belongs to whom

After this payment channel is set up once, it is possible for these two parties to conduct an unlimited amount of transactions without ever touching the information stored on the blockchain

With each transaction, both parties sign an updated balance sheet in order to always reflect how much of the bitcoin stored in the multi-sig wallet belongs to whom

The updated balance sheet is not uploaded to the blockchain but rather both parties keep a copy of it

Whenever there is a dispute or the payment channel is closed, both parties can use the most recent mutually signed balance sheet to pay out their share of the multi-sig wallet

This all sounds very cumbersome, but in fact for the end-user hardly any additional effort is needed to conduct Lightning payments, all of the above will happen automatically in the background.

The Lightning Network’s use of payment channels effectively allows users to transact with each other directly rather than broadcasting their business to the entire world (aka public blockchain). By tracking their payments between each other on their own, the two parties are able to avoid expensive and time-consuming interactions with the blockchain. If there is some sort of dispute regarding balances on the Lightning Network, the most recent balance sheet provided by either of the two parties will decide how the funds in the multi-sig wallet are split up.

To better understand how the Lightning Network works, we recommend watching this short video:

4) Do I need to open new payment channels for every new party I want to transact with?

No, the Lightning Network is (thus its name), constructed as a network. Meaning although Alice might not yet have an open payment channel with Dave, Alice is indirectly connected with Dave via Bob, or even using multiple steps in between. With the Lightning Network, users are able to transact with anyone who is connected to their network of payment channels through multiple hops. In theory, everyone should be connected to everyone else through the network via only few nodes. People are also incentivised running these connecting nodes through (small) fees that are paid out every time a transaction uses one of their connections. Early results from the testnet implementation of the Lightning Network confirm that a sufficiently decentralized network indeed can be created.

The architecture of the Lightning network is still trustless (because it is based on smart contracts) and will always make sure that the funds will reach their destination through intermediaries, or issue a refund if there is no indirect path to the destination possible.

Bob and Carol function as “nodes” on the network. Nodes on the Lightning Network are in some ways analogous to miners on the Bitcoin network. They function as the servers that process the transactions on the network in a decentralized manner. Like miners, they do not have control over the funds they help move. Bob cannot steal Alice’s funds, as he will only receive the sender’s incoming payment if he has already sent the outgoing payment to the recipient.

5) Benefits

Tiny payments are possible: Since fees are proportional to the payment amount, you can pay a fraction of a cent; accounting is even done in thousandths of a satoshi.

Payments are settled instantly: The money is sent in the time it takes to cross the network to your destination and back, typically a fraction of a second.

Improved privacy: Not every transaction is stored on the public blockchain, only once when the payment chanel is eventually closed and the balance is paid out to both parties

6) Shortcomings

Peer failures: If one of the peers is unresponsive, users might have to wait for hours to close a payment channel and resend the funds via an alternative route

No Offline Payments: Users can’t pay someone who is not online

Not ideal for large payments: Even though a route via various payment channels might exist, the funds in the peers multi-sig wallets might not be sufficient to transfer large funds

Centralization: The Lightning Network might encourages centralization in payment hubs (similar to miner centralization)

7) When will Lightning Network be launched?

Currently, there is a Proof-of-Concept implementation running on the Bitcoin Testnet and even an experimental implementation on the Bitcoin Mainnet. So everybody can try out the Lightning Network and even set up their own Lightning Node already today. A date when the Lightning Network will be widely launched on the Bitcoin Mainnet with integrations into the major wallets is not yet set, but chances are high it will be sometime this year.

Update March 16th: Lightning Labs just announced a new mainnet release of their implementation of the Lightning Network.