Bitcoin – the original and most well-known cryptocurrency – has limitations newer cryptocurrencies are not burdened with. Largest amongst these limitations is scalability. Bitcoin processing speed is very slow when compared to other payment processors, contained to just 7 transactions per second versus 4,000 by VISA, Bitcoin needed a solution to address this shortcoming with scalability.
Enter the Bitcoin Lightning Network, the blockchain community’s answer to the problem. Here is how it works. Traditionally, small transactions were stored on the main blockchain. The Lightning Network takes an off-chain approach, meaning payments are made in batches. For example, imagine someone named Bob purchasing a cup of coffee on the way to work every morning. Creating a transaction on the blockchain for a single cup of coffee would be overkill for such a small amount. Bob might end up spending more in fees than he does for the coffee.
With the Lightning Network, Bob can create a payment channel with the store. To do this, Bob and the store owner deposit a certain amount of Bitcoin in something called a multi-signature address.
The multi-signature address is like a virtual safe where Bitcoin is stored and can only be opened when both parties agree to do so. When a payment channel is created, a balance sheet is opened that instructs how the funds should be distributed. There is full transparency because the payment channel is opened on the main blockchain.
In this example, the store owner can see Bob deposited BTC and knows he will get his money once the channel closes. Bob changes the balance sheet and subtracts the cost of the coffee from his balance and adds it to the coffee shop’s balance. The balance sheet is signed with their private keys and each keep a copy. Bob can continue ordering coffee as long as he has a balance in the payment channel.
Both Bob and the store owner can make numerous transactions with really no limitations since they are made off the main blockchain. The payment channel is closed when either Bob or the coffee shop owner chooses to do so. The latest balance sheet – signed by both parties – is then broadcast to the Bitcoin network.
Miners will validate the signatures, and if everything checks out, release the funds according to the balance sheet. This will create just one transaction on the Bitcoin blockchain, thus reducing the load on the main blockchain. The Lightning Network requires just two transactions on the blockchain – one to open the payment channel and the other to close it.
The system is very safe because the system uses the latest signed balance sheet to unlock the money. Furthermore, users don’t need to open a direct payment channel with everyone they want to send Bitcoins to. The Lightning Network uses the best route from person A to person B, therefore using the least number of intermediates and the least amount of fees.
The Lightning Network has not yet gone live and is running as a proof-of-concept on the Bitcoin testnet. Chances are it will go live for everyone sometime in 2018.