In this guide, we will explain what is Lightning Network and how it works. We will try to keep this article as simple as possible and will not go into technical details. Before we dive deeper, you need to understand how Bitcoin transactions work now and what problems the Lightning Network is trying to solve.
How do bitcoin transactions work?
Currently, the Bitcoin transaction limit is only 7 transactions per second. This is very small compared to other off-blockchain solutions like Visa, which are capable of processing around 24 transactions per second. In addition, to protect the recipients of bitcoins, all transactions must be verified before the transaction is completed. This is called double-spending protection and works with the help of miners who confirm that the transaction actually took place. It usually takes 000 or 3 confirmations before the recipient can see the bitcoins in their wallet. 6 confirmation corresponds to the time it takes to find one block, which for Bitcoin is about 1 minutes.
Commissions are another obstacle. Bitcoin transaction fees at the beginning of 2020 ranged from 0,5 to 2 euros. On December 23, the transaction fee was 50 euros! If every time you send 100 or 1000 euros, you pay a small transaction fee - that's fine. But if you pay € 2 for a cup of coffee and another € 1 in transaction fees, the coffee will cost you a lot more.
This creates scalability problem and makes daily use, such as paying for coffee, nearly impossible. Imagine having to wait 30 minutes for coffee to be served, and besides, you have to pay 50% more for it.
What is the Lightning Network?
The Lightning Network was first introduced in February 2015 by Joseph Poon and Thaddeus Dry and was released in March 2018. The goal 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 enables faster transactions with lower fees.
The Lightning Network allows participants to create smart contracts and allows all transactions between these participants to be executed almost instantly. Transactions between participants within the contract are carried out outside the blockchain. Only the first deposit made to the contract (contract creation) and the last withdrawal (contract closing) are visible in the blockchain.
How does the Lightning Network work?
Lightning Network or LN allows all participants to deposit a certain amount into a shared wallet (contract), which is then immediately sent to another participant in the same contract after payment has been made.
Imagine John goes to the bakery every morning for bread. Instead of blockchain transactions every day and waiting 30 minutes (3 confirmations), John and the bakery owner enter into a smart contract that allows John to make an upfront payment of 0,005 BTC into this smart contract. At this stage, John still owns that 0,005 BTC and can return it whenever he wants.
The bakery owner is also a participant in this smart contract, but he does not need to deposit bitcoins, since he will only receive them. You can think of it as a wallet with two compartments, one for John's money and the other for the baker's money. The next time John comes to the bakery, he will be able to instantly send 0,0005 BTC to the baker. Bitcoins from John's branch will be transferred to the baker's branch off-chain.
But the baker will not be able to take advantage of this balance yet. Because the contract must be closed first. Any party involved can close the contract at any time. After the contract is closed, the balances will be sent back to John and Baker's wallet address in blockchain.
Lightning Network Is a great update for the Bitcoin protocol. But it imposes a new problem - the liquidity of the recipient participant. The baker may need these funds to pay for electricity or to buy flour, but he will have to wait until the contract is closed to receive the money.