Bitcoin’s Lightning Network: The Why and What

Bitcoin Lightning Network

In its most basic sense, Bitcoin is still referred to as a (crypto-)currency. While this is correct, it is worth emphasizing that the crypto asset is actually way more than just a currency. Bitcoin represents a new full-stack monetary and financial system that is rapidly growing in size and functionality. Most notably, a DeFi ecosystem built on and around Bitcoin is emerging in the form of protocols like RSK, Liquid, Stacks, Sovryn, or Mintlayer.

For this full-stack monetary and financial system based on Bitcoin to work, a global settlement layer is needed. Within Bitcoin, this base-layer is provided by the Bitcoin blockchain, sometimes also referred to as the Bitcoin mainchain. This is where Bitcoin transactions are getting settled with finality.

As a global settlement layer, the Bitcoin blockchain is capable of processing around three to seven transactions per second. This equates to approximately 600,000 transactions per day. Interestingly enough, this compares rather well to the daily number of transactions that the U.S. dollar’s base-layer settlement system called Fedwire is able to do. This goes to show that Bitcoin’s base-layer blockchain does indeed have to be compared to the real-time gross-settlement systems of central banks.

Prioritized for Security and Reliability

Because the Bitcoin blockchain is a settlement layer for a new financial system, it prioritizes security and reliability and is limited in transaction-processing time as well as transaction capacity. The target time between blocks is optimized for robustness and reliability, not rapid transaction speeds. In Bitcoin’s case, this means that about every 10 minutes on average, a new set of transactions in the form of a block is settled onto the Bitcoin blockchain with finality.

Enshrined in Bitcoin’s protocol rules is the fact that each new block of transactions must be replicated and propagated across Bitcoin’s entire network, meaning that each and every network participant must verify the validity of each block and the transactions it contains. This process takes time for every participant to perform, which is why the Bitcoin blockchain’s transaction-processing capability is calibrated to 10-minute intervals.

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Inherent Trade-Offs

Having security as well as reliability as a priority, the Bitcoin blockchain does not want to compromise on transaction-finality speed and must accept certain inherent trade-offs. One of them is: Bitcoin transactions happening on its base layer are noninstant settlement transactions. But not only are Bitcoin transactions not instantly settled but their overall capacity on the Bitcoin blockchain is also limited too. As a matter of fact, Bitcoin blocks can only hold a certain number of transactions as they are limited in their data capacity (the limit tends to not exceed ~1.3Mb). And because Bitcoin blocks are limited in data size, transactions have to compete for block space. With increased adoption, a Bitcoin-fee market has emerged ensuring that the transactions paying the highest transaction fees are being prioritized. 

This capacity limitation is the other trade-off, and it also derives from the fact that each and every network participant is programmed by the Bitcoin protocol to receive and validate every block of transactions happening within the system. While blocks could be made larger (exceeding the limit of ~1.3Mb to hold 2, 4, 8, or even larger amounts of Mb), greater stress would be put on network participants to process transactions. So, by minimizing participation requirements (computation, bandwidth, and storage), Bitcoin transactions can be validated by cheap and widely available computers. As a result, the network is kept accessible for as many participants as possible, adding the all-important decentralization of the Bitcoin network itself.

Scaling Bitcoin the Right Way

While it is decisive to keep Bitcoin as decentralized as possible, the network still has to have a way to scale. After all, what’s the point of a value-transfer network that allows users to easily validate transactions but not to use the system to make meaningful payments because they are either too slow or too expensive. Scaling Bitcoin and its network to make it fit for cheap and instant payments seems to be a must then.

One way of scaling the Bitcoin network and combating high fees, while keeping its degree of decentralization, is through implementing software upgrades like SegWit or Taproot. Despite these advancements, transactions are still not instant, and costs can only be brought down incrementally. To truly make small causal on-chain payments, so-called microtransactions, possible, another approach is needed. This approach comes in the form of scaling in layers. Transactions need to be outsourced to off-chain scaling solutions. This is where Bitcoin’s Lightning Network comes into play.

Introducing the Lightning Network

The Lightning Network is a second-layer (layer 2) payment protocol on top of the Bitcoin blockchain. While the Lightning Network is mainly seen as a potent scaling solution for Bitcoin, it is not exclusive to Bitcoin. As a matter of fact, the first-ever Lightning transaction had been conducted on Litecoin in 2017. Two years earlier to this, in 2015, the idea for the Lightning Network was introduced by Joseph Poon and Thaddeus Dryja, who published it as a whitepaper.

As a second-layer solution to Bitcoin, the Lightning Network represents its own protocol that works in conjunction with Bitcoin. In contrast to other Bitcoin-adjacent protocols or other cryptocurrency networks altogether, the Lightning Network does not have its own coin or token. Using the Lightning Network to make fast and cheap payments means that one is using Bitcoin through a protocol that works on top of Bitcoin.

Bitcoin units from the Bitcoin blockchain are transferred to the Lightning Network in a cryptographically secured way. Once these Bitcoin units are in the Lightning Network, they can be transacted off-chain. In economic terms, one could state that Bitcoin residing within the Lightning Network are so-called Bitcoin surrogates. For every ‘Lightning-network-Bitcoin’ there exists one ‘on-chain-Bitcoin’ on the Bitcoin blockchain. So, Lightning BTC and on-chain BTC exist in a 1-to-1 relationship, and while a Bitcoin resides within the Lightning Network, its on-chain counterpart remains locked on the Bitcoin mainchain.

History All Over Again — Just Better

Historically, this sort of setup existed with gold bars and gold-backed paper notes that were ultimately redeemable for physical gold. In the past, gold was used to settle transactions. Because precious metals were difficult to transport, paper certificates (money surrogates) backed by gold were created that circulated instead of the gold itself. Lightning transactions resemble payments with these paper surrogates. However, unlike most gold and money surrogates issued by banks, Lightning Bitcoin surrogates are fully secured and redeemable at all times. Thanks to cryptography, smart contracts, and a sophisticated incentive structure, the protocol ensures that one unit on the Lightning Network is always represented by one unit on Bitcoin’s base-layer blockchain.

Related: Are There Gold-Backed Cryptocurrencies?

So just like these gold-backed paper surrogates enhanced the transactability of physical gold, Lightning Bitcoin improves the transactability of on-chain Bitcoin. With the Lightning Network, Bitcoin gets the possibility to provide instant, low-cost, and high-capacity payments — after all, Lightning does away with the concept of a block such that payments are simply limited by the liquidity in each payment channel. One on-chain Bitcoin transaction can potentially power an unlimited amount of individual payments. This increases the economic density of on-chain Bitcoin transactions and makes Bitcoin’s financial system not only technically scalable but economically as well.

Using another analogy, we can conclude: While the Bitcoin settlement transactions on Bitcoin’s base layer are like container ships, Bitcoin Lightning Network transactions are like parcels delivering value that they can only do, thanks to these container ships in the first place.

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