What is Lightning Network and How Does It Work?

What is Lightning Network and how does it work?
In this guide, we will explain what the Lightning Network is and how it works. We will try to keep this article very basic without going into technical details. Before we dive in you must understand how Bitcoin transactions work now and what are the problems that Lightning Network is trying to solve.

How do Bitcoin transactions work?
Currently the Bitcoin transaction limit is only 7 transactions per second. Which is very low in comparison to other off-blockchain solution like Visa that is capable of processing around 24,000 transactions per second. Also, in order to protect receivers of Bitcoins, all transactions must be verified before the transaction is completed. This is called double-spend protection and it works with the help of the miners who confirm that the transaction really happened. It normally takes 3 or 6 confirmations before the receiver can see Bitcoins in his wallet. 1 confirmation equals one block time, which is around 10 minutes for Bitcoin.

Another obstacle is fees. Bitcoin transaction fees in early 2020 spanned from €0.5 up to €2. In December 23th, the transaction fee was €50! The small transaction fee that you pay every time you send an amount is very small if you send €100 or €1000. But if you pay €2 for a cup of coffee and another €1 for the transaction fees that coffee gets a lot more expensive.

This poses a scalability problem and makes everyday usage like paying for coffee practically unusable. Imagine waiting for 30 minutes until you get your coffee served and on top of that, you have to pay 50% more.

What is Lightning Network?
Lightning Network was first introduced in February 2015 by Joseph Poon and Thaddeus Dryja and was initially released in March 2018. The purpose of the Lightning Network is to solve the scalability problem of the Bitcoin blockchain. In short, the Lightning Network is a second layer protocol on the Bitcoin network that allows fast transactions with lower fees.

Lightning Network allows participants to create smart contracts and allows all transactions between these participants to be practically instantaneous. Transactions between participants inside the contract are made off the blockchain. Only the first deposit to contract (creating the contract) and the last withdrawal (closing the contract) is seen on the blockchain.

How does Lightning Network work?
Lightning Network or LN allows all participants to deposit some balance to a common wallet (contract) which is then instantly sent to another participant on the same contract when the payment is done.

Imagine that John goes to the bakery every morning to buy bread. Instead of making a blockchain transaction every day and waiting for 30 minutes (3 confirmations), John and the bakery owner make a smart contract that allows John to make an advance payment of 0.005 BTC to that smart contract. At this point, John still owns the same 0.005 BTC and can get it back whenever he wants to.

The bakery owner is also a participant in this smart contract, but he does not need to deposit any Bitcoin since he will be only receiving it. You can imagine this as a two-part wallet, on one side there is John’s money and on the other side is the baker’s money. The next time that John goes to the bakery, he will be able to instantaneously send 0.0005 BTC to the bakery. The Bitcoins from John’s side of the wallet will be transferred off the blockchain to the bakery side.

The bakery will not be able to use that balance yet. As the contract must be closed first. Either of the participants can close the contract at any given time. Once the contract is closed, the balances will be sent back to the John’s and bakery’s wallet address on the blockchain.

Lightning Network is a great upgrade to the Bitcoin protocol. But it imposes a new issue – liquidity of the receiving participant. A bakery might need these funds for paying electricity or to buy more flour, instead it needs to wait for the contract to be closed to receive the money.