Crypto Research

Lightning Network

Jun 22, 2021

Since the President of El Salvador is the first country to recognize Bitcoin as legal tender and also actively promotes and welcomes the construction of Bitcoin mining facilities between the volcanoes in El Salvador, the country - although these developments are relatively new - is on the right track in Bitcoin Everyday life.

The Lightning Network, Bitcoin's Layer 2 solution for fast and cheap transactions, was used in El Salvador and has therefore already driven up small Bitcoin transfers. At the time of writing, the Lightning Network has passed the 1,500 BTC (> $ 50 million) capacity milestone. Since the platform Strike, the world's leading digital wallet based on Bitcoin's Lightning Network, was launched for customers in El Salvador in March, Strike has quickly become one of the most downloaded apps in the country. According to data from blockchain analytics firm Chainalysis, monthly bitcoin transfers of less than $1,000 in May stood at $1.7 million, compared to $424,000 a year earlier. With the help of this technical infrastructure, Bitcoin can therefore be an incredibly efficient method for sending and receiving transfers.

But what is the Bitcoin Lightning Network?

The maximum transaction processing capacity for Bitcoin, which is estimated using an average or medium transaction size, is between 3.3 and 7 transactions per second. Compared to Visa, which can process an average of 3,000 transactions per second, Bitcoin is quite slow. And the more Bitcoin grows, the higher the transaction costs. But there is a solution that is always being worked on and that is called the Lightning Network. The main idea behind it is that everyday and smaller transactions do not have to be stored on the main blockchain, but happen off-chain.

The Lightning Network is its own network that can send and receive Bitcoin. This is a great advantage, since the transactions do not have to be mapped in the main layer (Layer 1) of Bitcoin and because Layer 1 of Bitcoin is relatively expensive - almost not usable for small payments. In order to achieve scalability and at the same time to maintain the security model and not to reduce the decentralization, one has to consider a solution with so-called Layer 2 and 3. In many ways, the blockchain itself can be viewed as Layer 1, which was developed on the basis of the internet (Layer 0), as the blockchain would not work without it. As a result, Layers 2 and 3 are created on the main blockchain and do not require any fundamental changes to the original blockchain. Lightning Network is viewed as Layer 2 protocols and runs above or alongside the protocol layer of a particular blockchain.

How does this network work?

Let's take an example: A customer buys a coffee for $3, which he makes with Bitcoin on Layer 1. The transaction costs are high and, depending on the priority, can be more expensive than the coffee itself. If the customer has the Lightning Network, the customer and the café could open a so-called payment channel. For this purpose, both parties deposit a certain amount of Bitcoin each on a so-called multi-signature address. Let's say the customer deposits 0.0030 BTC (worth $100) to a multi-signature address. In addition to the deposit, there is also a balance sheet showing who currently owns how much of the money. This means that the customer is entitled to 0.003 BTC at the beginning. This balance sheet also takes place on the main blockchain for everyone to see. If the coffee costs 3 USD - the equivalent of around 0.00091 BTC - the balance simply changes for the customer by this amount, so that the balance on the customer side is now 0.000091 BTC less and the café has 0.000091 BTC on its balance side. Both contracting parties provide this transaction with a digital signature with their private key and keep a copy of the balance sheet for safekeeping. The customer can now place dozens of orders according to this exact pattern, provided that enough money has been deposited for it. The payment channel can be canceled at any time by one of the partners. All you have to do is send the current balance sheet, signed by both, to the Bitcoin network (Layer 1). The miners then record these transactions in the blockchain and the money is released and split into a transaction and described in the balance sheet. This significantly reduces the load on the blockchain (Layer 1), as only 2 transactions are required:

- A transaction to open the payment channel and

- the second transaction to close the payment channel.

The interesting thing about these payment channels is that you don't have to open your own payment channels for each party. The payment channels can also be used by other parties, because it is only important that there is an overarching payment channel connection that leads from one party to the other and that enough money is deposited in this way. The system then automatically searches for the path with the fewest intermediaries. The incentive to leave your own payment channel open and make it available to others could be that you charge a small fee for it.

The Lightning Network and other Layer 2 solutions show that there are tools to support Bitcoin on its way to widespread adoption. Bitcoin is scalable and this instrument has already shown it.