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Lightning Network: What It Is and How It Works

Updated May 31, 2023

Reviewed by

ERIKA RASURE


What Is the Lightning Network?

The Lightning Network is a second layer for Bitcoin (BTC) that uses micropayment channels to scale the blockchain’s capability and handle transactions more efficiently and more cheaply. It is a technological solution designed to solve glitches associated with Bitcoin by introducing off-chain transactions. Its channel is a transaction mechanism between two parties, in which each can make or receive payments from the other.

KEY TAKEAWAYS
  • The Lightning Network is a technological solution intended to solve the problem of slow transaction speed on the Bitcoin blockchain by introducing off-chain transactions.

  • Like a primary blockchain, the Lightning Network removes from the transaction the financial intermediary, such as a bank, which is responsible for routing most transactions today.

  • Joseph Poon and Thaddeus Dryja were the first to formally propose the Lightning Network in a 2016 paper.


At first, Bitcoin was intended to be a decentralized payment system in which the users could remain anonymous and access it from anywhere. Bitcoin wasn't designed to be scalable. However, because Bitcoin's popularity created problems, a solution needed to be found.


Enter Lightning Network. To counter the situations of slow transaction speed and excessive energy use, developers created cryptocurrency layers, in which the first layer is the primary blockchain. Each layer beneath the first one is a secondary or tertiary layer and complements the layer above it and adds functions. The Lightning Network can also be used to handle other types of off-chain transactions involving exchanges between cryptocurrencies.


Understanding the Lightning Network

Joseph Poon and Thaddeus Dryja first proposed the Lightning Network in 2016, and it has been under development since then. The problems the Lightning Network was devised to solve were Bitcoin's slow transaction time and throughput, or processing time, as well as costs.


What Issues Does the Lightning Network Try to Address?


Bitcoin wasn't created to handle the vast number of transactions using it that now occur daily. Some issues the Lightning Network attempts to correct are:

  • Sluggishness in confirming transactions: It had become expensive and time-consuming because there are many users transacting, and mining difficulty increases over time. The increase in transaction numbers required improving the manner in which transactions were confirmed.

  • High energy costs: The energy necessary to compute this information is enormous, making maintaining the Bitcoin blockchain prohibitively expensive.

  • Ensuring that designated recipients receive the funds they are entitled to: Smart contracts and multi-signatures are the backbone of the Lightning Network, used to ensure the funds sent through the channels make it to the right recipients.


The Lightning Network uses channels between participants, so that multiple transactions can be handled without waiting for the slower main net to confirm single exchanges. Between the opening and closing of a channel, parties can shift funds between themselves as needed until they close the channel. Once the channel is closed, the transactions go to the main net for confirmation.


Concerns About the Lightning Network 

The most obvious problem with the Lightning Network is that it could lead to a replication of the hub-and-spoke model that characterizes today’s financial systems. In the current model, banks and financial institutions are the primary intermediaries through which all transactions occur.


Businesses that invest in Lightning Network nodes may become similar hubs or centralized nodes in the network by having more open connections with others. Other concerns are fraud, fees, hacks, and price volatility.


Closed-Channel Fraud


One risk when using the Lightning Network is closing the channel (logging off) and going offline. For example, suppose Sam and Judy are transacting, and one has malicious intent. The dishonest party may be able to steal coins from the other participant using a technique called "fraudulent channel close."


Let's say Sam and Judy each put up an initial deposit of 0.5 BTC to open a channel, and a transaction of 1 BTC has taken place in which Sam purchased goods from Judy. If Judy logs off (closes the channel) after transferring the goods and Sam doesn't, Sam could broadcast the initial state (the time before the 1 BTC was transferred), meaning they both get their initial deposits back as if no transactions were done. In other words, Sam would have received 1 BTC worth of goods for free—and the deposit is returned.


This makes it necessary for third parties to run on nodes to prevent fraud within the Lightning Network, called a watchtower. The watchtower monitors the transactions and helps prevent a fraudulent channel close.


Fees


Transaction fees are associated with using the Lightning Network. They are a combination of routing charges for routing payment information between Lightning nodes, opening and closing channels, and Bitcoin’s usual transaction fees. Additionally, because the watchtowers are third parties, many charge fees for this service.


Once two parties settle the bill between themselves, they must record a closing transaction for the agreed amount on the blockchain, which includes the fee charged for forwarding the transactions. This is either a base fee (a set fee) or a fee rate (a percentage of the transaction).


Hacks

The Lightning Network is also believed to be vulnerable to hacks and thefts because payment channels, wallets, and application programming interfaces (APIs) all can be hacked.


Fast Fact
Individual payment channels between various parties combine to form a network of Lightning Network nodes that can route transactions among themselves. The interconnections between different payment channels result in the Lightning Network.

Malicious Attacks

Another risk to the network is congestion caused by a malicious attack. If the payment channels become congested, and there's a malicious hack or attack, the participants may not be able to get their money back fast enough due to the congestion. Attackers can also use a denial-of-service attack to congest a channel, essentially freezing it.


In these types of attacks, the attacker could use the congestion to steal funds from parties who are unable to withdraw their funds because of the network freeze.


What Is the Lightning Network?

The Lightning Network is a second layer for the Bitcoin blockchain, which serves to speed up transaction times and decreases network congestion. It is a technological solution designed to solve problems associated with the Bitcoin blockchain by introducing off-chain transactions. Its channel is a transaction mechanism between two parties, in which the each can make or receive payments from the other.


Can I Invest in the Lightning Network?

While you are unable to directly invest in the Lightning Network, private investors can invest in Lightning Labs, the company behind the network.


Who Runs the Lightning Network?

Lightning Labs, led by Elizabeth Stark, is the company that developed the Lightning Network. The network itself is deployed on the internet and runs on thousands of nodes located around the world.


The Bottom Line

The Lightning Network, developed by Lightning Labs, is a second layer for Bitcoin, which uses micropayment channels to scale the blockchain’s capability and handle transactions more efficiently and more cheaply. It is a technological solution designed to solve problems that arise from using Bitcoin, through the use of off-chain transactions. The Lightning Network isn't impregnable and may be subject to various schemes, such as replication of the hub-and-spoke model, closed-channel fraud, hacks, and malicious attacks.


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