As cryptocurrencies have evolved over the years, first-generation coins such as Bitcoin have begun to struggle since more agile, forward-thinking altcoins have started to offer more functionality and efficiency. Sluggish transactions and hefty fees have plagued Bitcoin recently, but the adoption of the Lightning Network as an off-chain solution could give the world’s first cryptocurrency a new lease of life, and is all the talk of our Bitcoin social feed.
In this guide, we will explain what the Bitcoin Lightning Network is, how to use it, and the Lightning Network security benefits for Bitcoin.
What is the Lightning Network?
The issue with the blockchain technology underpinning the Bitcoin cryptocurrency is simply scalability. The lack of scalability is largely due to the requirement of Bitcoin nodes to oversee and approve transactions via the Bitcoin blockchain, which puts a ceiling on the number of transactions that can be processed per second.
While Bitcoin nodes offer a much-needed layer of security to guard against the threat of cybercriminals, off-chain scalability solutions such as the Lightning Network can make the world of difference to legacy crypto assets such as Bitcoin. Without this solution, the Bitcoin network can only process up to an average of seven transactions per second. When you consider that the Bitcoin Cash altcoin can already process an average of 61 transactions per second, it is easy to see that Bitcoin needs the Lightning Network to overcome the limitations of blockchain technology.
The implementation of the Lightning Network Bitcoin solution helps to enable quicker peer-to-peer transactions. Simply put, the Lightning Network is designed to sit on top of an existing blockchain network — in this case, the Bitcoin blockchain, complete with its own Lightning node (about which we will elaborate later) and software.
How does the Lightning Network work?
The Bitcoin Lightning Network operates separately from the Blockchain network, but works in tandem with it, communicating with the main blockchain. The Lightning Network requires its very own nodes and software to work with the Bitcoin blockchain.
For rapid Bitcoin transactions to be made across the Lightning Network — without the need to wait for block confirmations — two peers need to be looking to buy and sell Bitcoin to and from each other. In addition, a multisig BTC lightning wallet must first be created. This is to provide a secure segue for any peer-to-peer Bitcoin transactions.
First and foremost, the wallet must be saved onto the Bitcoin blockchain. A mini-ledger known as a “channel” is then created using smart contract functionality that is more commonly attributed to Ethereum. These channels are only visible to the buyer and seller. Unlimited transactions can be made between these two parties in lightning-quick fashion; crucially, without the need to update any information housed within the Bitcoin blockchain.
With each peer-to-peer Bitcoin transaction, both parties must sign and agree to a revised balance sheet, confirming the amount of Bitcoin within the wallet that is owned by each party. Once both parties have concluded their transactions, the secure mini-ledger can be closed.
Lightning Network Pros & Cons
There is no doubt that the concept of a Lightning Network for Bitcoin is gaining traction and momentum, with many considering it to be the quickest and cheapest decentralised way to complete a Bitcoin transaction. Accordingly, interest in investing in Bitcoin is growing alongside the Lightning Network’s visibility, with a deepening buyer awareness of this viable transaction speed booster.
Let’s delve a little deeper into the pros and cons of Bitcoin’s prospective Lightning Network payments. This will hopefully give you a balanced perspective of whether it can solve the cryptocurrency’s long-term issues of slow transactions and high fees, which could see the value of Bitcoin soar.
- Built for speed
First and foremost, the Lightning Network does exactly what it says on the tin — complete transactions faster from peer-to-peer. There is no need to wait for block confirmations or nodes to acknowledge the transfer, with smart contracts overseeing the allocation of funds via a multisig wallet.
- No minimum payments
With the Lightning Network, transferring even the smallest amount of Bitcoin from peer-to-peer becomes a cost-effective process. All transactions, however small, are processed and settled immediately.
- Reduced fees
Utilising the Lightning Network will also drastically reduce transaction fees. Those wishing to make larger transactions will no longer incur such hefty processing charges.
- Lightning Network Bitcoin transactions are 100% anonymous
All Bitcoin transactions conducted within a mini-ledger channel on the Lightning Network are fully anonymous and encrypted. It is not until a channel is closed that all transactions completed and signed for, are then recorded onto the Bitcoin blockchain.
- No offline support
Arguably the greatest drawback of the Lightning Network for Bitcoin users is that offline transactions are unsupported. Those who do not have immediate Internet access will be unable to participate; which is arguably counterintuitive for those first figuring out how to use the Lightning Network.
- Heavily reliant on the other peer
As the Lightning Network creates fast peer-to-peer channels for Bitcoin transactions, a buyer is heavily reliant on their seller to be responsive about transferring funds.
- Reduced fees are also seen as damaging to the sustainability of Bitcoin’s network
Lower fees for Bitcoin transactions can also be viewed in a negative light for the Bitcoin network. Once all Bitcoins have been mined, transaction fees will become the only financial rewards available to miners overseeing the Bitcoin blockchain. Without these fees, Bitcoin’s sustainability could be called into question.
What are Lightning Network nodes?
Although the prospective Bitcoin Lightning Network will operate off-chain, it will still require Lightning Network nodes to interact with each other to transfer funds and to continue to monitor the underlying Bitcoin blockchain.
Each Lightning Network node has the responsibility of monitoring the blockchain in which it retains tokens. There is a risk that if a node does not monitor the underlying blockchain, funds can be unwittingly stolen. Nodes on the Lightning Network will be required to keep a note of who is transferring what within each Lightning channel. These nodes must only monitor the validity of Bitcoin transactions with which they deal directly, while Bitcoin nodes have a much greater task of verifying every single transaction processed within the Bitcoin network.
A trio of development teams are already working hard to build these Lightning Network nodes — Lightning Labs, ACINQ and Blockstream. When will the Lightning Network be implemented for Bitcoin? As of November 2020, some 14,339 nodes are already online overseeing over 35,201 active channels. It is important to note that the Bitcoin Lightning Network is still very much in its infancy but, while it will not solve all of Bitcoin’s problems, it is likely to be a major step forward. You may also encounter the Lightning Network when transacting with other altcoins peer-to-peer such as Litecoin, so it is well worth familiarising yourself with the technology.
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This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.