Bitcoin’s scalability issues mean that smaller transactions can congest the blockchain. The Lightning Network was created to fix that.
Since each block on Bitcoin’s blockchain takes an average of 10 minutes to process, only a small number of transactions can go through at a time. In 2016, developers Thaddeus Dryja and Joseph Poon proposed an idea that could enable fast and cheap transactions on the network without having to change the block size. They called it, the "Lightning Network.”
The Lightning Network creates a second layer on top of the bitcoin blockchain that uses user-generated, micropayment channels to conduct transactions more efficiently.
These transactions are much faster than regular bitcoin transactions because they don’t need to be broadcast to the entire network. And because there are no miners that need incentivizing, transaction fees are low or even non-existent.
How it works
Think of Bitcoin’s main blockchain as a highway, and the Lightning Network as a series of side streets that reduce the highway's congestion from smaller transactions.
First, two parties who wish to transact with each other set up a multisignature wallet (which requires more than one signature to enact a transaction). The wallet holds some amount of bitcoin. The wallet address is then saved to the Bitcoin blockchain, setting up the payment channel.
The two parties can now conduct an unlimited number of transactions without ever touching the information stored on the blockchain. With each transaction, both parties sign an updated balance sheet to reflect how much of the bitcoin stored in the wallet belongs to each.
Once the two parties finish transacting and close out the channel, the resulting balance is registered on the blockchain. In the event of a dispute, both parties can use the most recently signed balance sheet to recover their share of the wallet.
It is not necessary to set up a direct channel to transact on the Lightning Network – you can send payments to someone via channels with people with whom you are connected. The network automatically finds the shortest route. The network's goal is to allow users to make smaller payments without transaction fees or delays.
Where are we now with the Bitcoin Lightning Network?
The Lightning Network launched a beta version in 2018, but was far from fully operational. Since then, the number of nodes on the Lightning Network has doubled year over year, moving the project closer to achieving its goal of making bitcoin a viable currency for day-to-day transactions.
The network went from 6,040 nodes in July 2020 to 12,675 in July 2021, a 105% increase. It should be noted that this includes only public nodes (nodes accessible to anyone). The number of total nodes is much higher if you were to include private connections (nodes accessible only to permissioned users).
Despite significant growth in recent years, the Lightning Network still faces challenges to overcome if it wants to solve bitcoin’s scalability issues. The most demanding issue is security. Because nodes on the Lightning Network are required to always be online, they become more vulnerable to attacks. And while the network aims to reduce fees incurred from processing transactions on bitcoin’s main network, it includes its own set of additional costs for opening and closing channels, along with routing fees. These are issues that will likely be solved with time, as its technology develops and becomes fully optimized.
Exchanges are also beginning to adopt the technology to optimize their users’ bitcoin withdrawals and deposits. Kraken recently announced that it will be adding support for the Lightning Network in 2021, as will the U.K.’s CoinCorner, Vietnam’s VBTC and San Francisco-based OKCoin. The adoption of Lightning by prominent exchanges is good news for the network’s future, and while most agree that the Lightning Network won’t be the solution to all of bitcoin’s future challenges, it will certainly play an important role in the cryptocurrency’s future.
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