Since Bitcoin wasn’t originally designed to be scalable (but rather with intention to create a robust decentralized peer-to-peer payment system) and has already gained traction when it comes to institutional (and even government) adoption, many investors think of digital gold as having a pretty low potential, looking at it from an investment perspective. What these investors don’t know is that BTC actually has a solution in terms of scalability, called Lightning Network.
What is it? What problems does it promise to address? Are there any concerns about it? In case these questions sparked any interest, I suggest you continue reading, as we’ll dive into Lightning network and try to answer all these questions (and even some more). Let’s get right into it!
What is the Lightning Network and how does it work?
This layer 2 technological solution promises to improve the processing time and number of transactions, by using smart contracts to establish payment channels between users. These channels are like a digital version of a bar tab between two parties, which allow almost instant transactions that are settled off-blockchain. Since users don’t verify transactions using the blockchain, payments can be processed almost instantly. Additionally, transactions are also cheaper, since users don’t have to pay the Bitcoin network’s high fees for every transaction. Once two users decide to close their payment channel, they settle their final balances on the core blockchain.
To optimize things even further, the network doesn’t need to have channels between all users. For example, if you have a channel with two other users, they don’t need to have a channel directly between them in order to facilitate transactions among each other. Funds can be transferred through the two channels that connect you and both other users.
All you need to do in order to start using the Lightning network is transfer some of your Bitcoin holdings to a Lightning-compatible wallet, which is prerequisite to a payment channel. Once the channel is created you can conduct microtransactions via Lightning Network. In case your balance reaches zero, you need to top up your wallet, if you want to keep the channel open and continue conducting transactions. Once you decide to close the channel, the transactions are sent to the Bitcoin network for confirmation.
What problems does it promise to address?
When Bitcoin was conceived back in 2009, it wasn’t designed to handle the amount of transactions it needs to conduct daily nowadays. Satoshi Nakamoto successfully designed a decentralised peer-to-peer digital cash system that was supposed to be robust and immune to hacks or any other malicious activities. As already mentioned, his (their - in case it was a group of people) goal was not to create a protocol that could handle the most transactions at a time, but rather to enable people to securely transact value outside without any third party intermediaries, such as Banks and other financial institutions, as well as governments (mostly indirectly).
The Bitcoin network has stood the test of time when it comes to its initial purpose, but has been falling behind other cryptocurrencies in the matter of scalability. Many other crypto networks are able to process tens of thousands of transactions per seconds, while the Bitcoin network can only process up to 7 transactions per second. Having successfully recognized this functionality problem, Joseph Poon and Thaddeus Dryja devised the Lightning Network back in 2016 with the aim to solve Bitcoin's slow transaction time and throughput through micropayments.
Without the Lightning Network users would have to pay high fees for every transaction and then wait for an hour for it to validate (it usually takes a little less, but when the network gets congested it can take several hours for a transaction to get validated).
It is important to note that it usually takes more time for smaller transactions, because miners choose to validate larger transactions as they’re incentivized by larger rewards for doing so. To add insult to injury, small transactions carried out on the Bitcoin network already suffer from relatively high network fees, which altogether makes the BTC network rather useless for microtransactions. Thankfully, we’ve now got the Lightning Network which solves all these problems. But, are there any new problems it creates in the process?
Are there any drawbacks that come with it?
Because the Lightning Network is a separate network that exists as a layer on top of Bitcoin, it is more vulnerable to hacks and thefts. Unfortunately, you can’t really have the best of both worlds. A protocol that focuses on security, can only do so at the expense of scalability and vice versa. Therefore you have to make a security compromise when using the Lightning Network. To some degree, this isn’t that big of a drawback, since you can opt for the Lightning Network for smaller transactions (where you put only a small amount of funds at risk) and use the main blockchain for bigger transactions.
When judging how useful and needed the Lightning Network is, we need to ask ourselves the following question: ‘Is there actually real demand for such a network and if that is the case, how big it is?’. Although Bitcoin was designed to serve as a peer-to-peer digital cash system, more and more crypto experts now see it as a digital gold. Why? Because BTC’s value has appreciated so much over the past years, it is not really viable as a medium of exchange. The majority of people buy Bitcoin in order to hedge against inflation, not to use it for transactions.
Nevertheless, there is some (increasing) demand for the Lightning Network, as there is 300% more BTC locked within the network in comparison to a year ago. This could come as a result of the bear market crypto has been going through since the start of the year or a consequence of real demand for such a network from people who are willing to use Bitcoin to settle transactions. We’ll see if this demand keeps up, once the crypto market starts hitting new highs. In the long run, it doesn’t really matter, as the crypto market will probably eventually stabilize, helping Bitcoin become more suitable as a form of payment.
