The Lightning Network: The off-chain and second-layer solution for Bitcoin

5. November 2023

Bitcoin, the world’s most prominent cryptocurrency, has a significant scalability drawback – its transaction speed with long processing times, high fees, and corresponding energy consumption (Bitpanda, 2023). This has prompted many smaller cryptocurrencies, known as altcoins, to challenge Bitcoin due to its slow speed and high costs. Nonetheless, the so-called Bitcoin dominance remains at around 50% (Coinmarketcap, 2023). To address Bitcoin’s weaknesses, the so-called Bitcoin Lightning Network was introduced. The paper with the title “The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments” was provided online by Joseph Poon and Thaddeus Dryja 2016 and still show current relevance (Lightning Network, 2023). The world’s largest crypto exchange, Binance, recently announced the integration of the Lightning Network for Bitcoin deposits and withdrawals (Binance, 2023). The crypto platform Coinbase is also ogling with the integration, thereby promising faster and cheaper transactions for its users (BTC-Echo, 2023). This indicates that the network is gaining increasing importance in the crypto community.

The main concern many critics have with Bitcoin is the duration of transactions. Currently, the Bitcoin network can process only about seven transactions per second (TPS), with transaction fees often being exorbitant. The problem lies in the structure of the blockchain itself, which prescribes a fixed size for transactions. The Lightning Network is a continuation of the original Bitcoin technology and is designed to dramatically increase the speed of Bitcoin transactions – up to one million TPS. To put this into perspective: the card payment organization Visa can process up to 65,000 transactions per second (Cointelegraph, 2022).

A primary reason for the slow Bitcoin transactions is the block confirmation time. Each block added to the Bitcoin network takes about ten minutes, increasing both the time and energy consumption for transactions. Figure 1 shows a comparison between Bitcoin and the most relevant altcoins with regards to TPS and the confirmation time for transactions:

 

Figure 1: Transaction per seconds and confirmation time – Bitcoin versus altcoins

Source: Phemex, 2022

 

The Bitcoin Lightning Network revolutionizes this process, thereby operating independently of the main blockchain and allows for nearly instantaneous transactions at a fraction of the cost (Heise, 2019). Fees for the Lightning Network are well below $0.01 per transaction. Put simply, users wishing to make transactions on the Lightning Network don’t process them directly on the Bitcoin blockchain. Instead, they use a dedicated Lightning wallet. This sets up a parallel „Offchain Payment Channel“ where transactions are executed without being immediately logged on the primary blockchain, enabling transactions to be completed in a matter of seconds. Only when this channel is terminated is the conclusive transaction authenticated and noted on the Bitcoin blockchain. The Bitcoin Lightning Network marks a transformative advancement in cryptocurrency. It addresses previous limitations of Bitcoin and sets the stage for a time when digital currencies can truly be used as a regular mode of payment (TUM, 2023).

A current study conducted by the financial services company River indicates that the Lightning Network shows a growth of +1212% within two years. Using information from node operators that make up 52% of the public capacity on the Lightning Network, the calculations made by river suggest a minimum of 6.6 million Lightning transactions in August 2023. They expect even higher numbers, provided data on direct and private interactions between users would have been available and included. This demonstrates a growth of 1,212% from the 503.000 Lightning transactions recorded in August 2021. This surge occurred despite Bitcoin’s price dropping by 44% and a 45% decline in search interest. This amounts to an average of 2.5 transactions every second, in contrast to Bitcoin’s on-chain rate of 4.4 TPS and 0.2 TPS in August 2021. The findings underline the successful adoption of the second-layer solution (River, 2023).

The works on the Lightning Network are still ongoing, but in its current state it already proves to be an eligible second-layer solution for bitcoin:

  • Greater scalability: The Lightning Network’s capability to handle transactions off the blockchain significantly diminishes the need for recording them on the primary blockchain. This boosts its capacity, facilitating a higher volume of simultaneous transactions.
  • Swift processing: In the peer-to-peer setup, the Lightning Network delivers transactions at an impressive speed. They often require minimal hops and frequently reach their destination quicker.
  • Cost-effective: With a vast community of Bitcoin aficionados, the expenses linked to Lightning transactions are notably lower than many other options. By early 2023, the typical charge for such a transaction sits at around 0.00008€, positioning Bitcoin as one of the most economical international payment methods.
  • Augmented privacy: The design of the Lightning Network permits users to engage in exchanges off the blockchain, bolstering transactional confidentiality. This is because the specifics aren’t chronicled on the universally accessible blockchain. Furthermore, encryption ensures both the transaction’s sender and receiver are masked, keeping the payment’s intended recipient unknown.

 

Although it presents some upsides compared to standard Bitcoin transactions, there are still notable concerns to be aware of:

 

  • Adoption challenges: As the Lightning Network is in its nascent phase, it hasn’t been widely adopted. This situation creates a potential accessibility issue for some, mirroring a classic chicken-and-egg dilemma.
  • Intricacy: Navigating the Lightning Network demands a decent grasp of technical nuances. Those not well-versed in cryptocurrency technicalities might find it challenging.
  • Security concerns: With all emerging technologies, there’s a potential for uncovering vulnerabilities in Lightning Node setups as time progresses. Users should be vigilant about the associated risks and initiate payment channels primarily with entities they trust.
  • Support limitations: Echoing the adoption point, not all Bitcoin wallets and trading platforms accommodate the Lightning Network, potentially narrowing its practicality.

 

All in all, the Lightning Network can state many successful facts, thereby proving the raison d’être for the global crypto community as well as for the private users to perform daily microtransactions in an efficient manner. Despite the so-called “crypto winter”, the network shows stable numbers in terms of usage and growth. It remains to be seen how the adoption will progress and if Bitcoin can emerge to a globally accepted payment alternative to fiat money. If latter is the case, then the Lightning Network will inherit an essential role in the adoption process and might grow exponentially.

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