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What Is the Bitcoin Lightning Network? How Does It Work?

By Brian Nibley · July 09, 2021 · 5 minute read

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What Is the Bitcoin Lightning Network? How Does It Work?

The Lightning Network, or “Lightning” for short, provides a way for Bitcoin users to make small transactions without hefty fees or long confirmation times. While it’s not yet available to the average Bitcoin user, this innovation could one day solve Bitcoin’s biggest problems—high transaction fees and long confirmation times—both of which make smaller everyday payments unfeasible.

On the list of things to know before investing in crypto, Lightning doesn’t even crack the top five. But it may be an interesting topic for those interested in the technical side of blockchain technology, and for those who want to use Bitcoin as a means of payment.

What Is the Lightning Network?

Lightning is a decentralized network that uses smart contract functionality in the Bitcoin blockchain to facilitate instant payments across a network of users. It’s considered an off-chain or layer-2 solution because it involves activity that doesn’t occur directly on the blockchain.

Why Does Bitcoin Need Lightning?

Due to its decentralized nature, which requires consensus across a broad range of different computers, the Bitcoin network can only process about 7 transactions per second on average. Compare this to 24,000 transactions per second on average for a traditional credit card company like Visa.

Transaction fees, while still relatively low for larger transactions, are too high for micropayments. Sending $5 worth of Bitcoin on-chain isn’t often worth it because the fees would be so large. At times of high network congestion, the fees could even exceed the cost of such a small transaction, making it impossible.

It also tends to take several minutes, if not longer, for a Bitcoin transaction to be confirmed by the network.

Imagine buying a cup of coffee with a direct transaction on the Bitcoin blockchain. After payment, the merchant would have to wait at least a few minutes to receive the funds. The basics of Bitcoin don’t make everyday use easy. The debate over the problem of how to make Bitcoin scale has led to a number of Bitcoin forks since 2017.

Lightning provides a creative solution for these problems.

How Does the Bitcoin Lightning Network Work?

First, users must establish their own multi-signature Lightning wallet, and the two parties involved exchange a single key to validate their spending transactions. In this way, the transactions are kept from being broadcast on the main Bitcoin blockchain while also being verifiably accurate and real.

These off-chain (layer 2) transactions occur independently of on-chain (layer 1) transactions and don’t have to be updated on the main blockchain unless the two parties open or close a channel. Many Lightning Network transactions can occur before their record is broadcast to the blockchain. In this way, fees and confirmation times are greatly reduced.

Lightning uses multi-signature scripts and smart contracts to achieve its goals. When two parties initially fund a channel, this is called a “funding transaction.”

In effect, people are creating their own mini lightning networks when they open a Lightning wallet. Sometimes these multi-signature lightning wallets are referred to as “payment channels” or simply “channels.”

Example of How Bitcoin Lightning Network Works

As more and more people connect to Lightning, they don’t always have to create their own multi-signature wallet for each and every person they want to transact with. As the network grows, so do connections between wallets, and so long as there is a wallet with sufficient funds that the transaction can be routed through, then new users may be able to make use of existing wallets.

For example, imagine that James opens a channel with his local hardware store and deposits $50 of Bitcoin. His transactions with the hardware store can now be facilitated using the Lightning Network instantly.

Heather, who has a different channel open with her local smoothie shop, buys hardware from the same store as James. The connection between James, the grocery store, and Heather makes it possible for James to buy smoothies from the smoothie shop using the Lightning balance he has with the hardware store. Heather can also use her smoothie shop balance to facilitate transactions with other businesses within James’ network.

If Heather were to close her channel with the smoothie shop, then James would have to open a new channel with the smoothie shop to make Lightning purchases there, assuming there are no other available channels open. But as the Lightning Network grows, the idea is that in time, many different customers will have channels with many different merchants, and there will eventually be enough channels for everyone.

Lightning Network Developers

Who is developing the lightning network? There are a number of startups working on different implementations of lightning Bitcoin. The three main developers are listed below, each of them using a different programming language. Input is given from other members of the bitcoin community as well.

Lightning Labs

Lightning Labs focuses its efforts on creating a working model of the Lightning Network. The company is currently developing a Lightning Network Daemon written in the Golang programming language.

Blockstream

Blockstream is known for the creation of satellites that serve as backups for the Bitcoin blockchain in the event of anything catastrophic happening to miners or the electrical grid on Earth.

When it comes to Lightning, the company is working on a version written in the C programming language.

ACINQ

The company is developing Lightning using the Scala programming language.

It’s worth noting that while these versions are written in different languages, tests have shown that the three primary implementations could be interoperable, meaning they could all work together.

Pros and Cons of the Lightning Network

Perhaps the most important benefit of the Lightning Network is that it will allow Bitcoin to scale. Users will be able to make instant micropayments using Bitcoin without paying high fees. The famous example is buying a cup of coffee with Bitcoin, which is all but impossible at present due to high network fees and slow confirmation times.

One con includes the fact that as of the time of this writing, Lightning is not quite available for practical use. Because the project is still under development, it hasn’t yet been universally applied to real-world applications.

The average user will have difficulty making transactions using the Lightning network. Unless someone runs their own Lightning Bitcoin node, they won’t be able to receive payments while offline, and may or may not be able to open a channel with another person or merchant (who must also be using Lightning).

Can You Make Money Running a Lightning Node?

Running a Lightning node doesn’t involve anywhere near the kind of rewards that mining bitcoin does. There are several reasons someone might want to run a Lightning node, such as helping the Bitcoin network scale, increased privacy for personal transactions, and bypassing censorship in areas where governments have heavily regulated crypto and crypto exchanges.

Making money is not an incentive for running a Lightning node, however, as it typically doesn’t pay more than a few pennies per month at most. The hardware required to run a node will cost about $200-400 on average.

The simplest of tips for investing in Bitcoin might be to not run a full node unless you have a good reason or want to support the growth of the technology.

The Takeaway

The Lightning Network is a layer-2 solution that provides a way for Bitcoin to scale. It is still in the early experimental development phase, but once it becomes fully developed and widely adopted, it could help make Bitcoin more widely used as a digital medium of exchange.

While the Lightning Network will primarily benefit users interested in Bitcoin as a form of payment, there are other users who consider Bitcoin to be more of an investment. For those interested in investing in cryptocurrency like Bitcoin, Ethereum, and others, SoFi Invest® offers a secure platform that keeps assets protected from fraud, and the convenience of 24-hour trading through the SoFi app.

Find out how to get started with SoFi Invest.

Photo credit: iStock/MicroStockHub


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