In 2015, Gavin Andresen, a prominent Bitcoin Core developer, published a Bitcoin Improvement Proposal (BIP) proposing a hard fork to the Bitcoin protocol that would double the maximum block size every two years. This struck at a fault line within the community.
A new block of transactions is added to the Bitcoin network every 10 minutes, which means that the throughput of the network — or the speed that it can process transactions — is limited by how big the block is, or, equivalently, how many transactions can fit inside each block. Andresen believed that bigger blocks would help the network scale. Many others disagreed, arguing that bigger blocks made it harder for people to run nodes on the network, compromising decentralization and potentially posing security risks. Without increasing the block size, however, it was hard to see how Bitcoin could scale.
In 2016, Joseph Poon and Thaddeus Dryja published a paper hoping to solve all of this by proposing a network of micropayment channels that could settle BTC transactions outside of the Bitcoin blockchain (a.k.a. “off-chain settlement”), thereby alleviating the load on the main Bitcoin chain. It’s what we refer to today as the Lightning Network.
In this article, we’ll dive into what the Lightning Network is, why it matters, and how far along it’s come today since the original 2016 white paper.
How Do Lightning’s Payment Channels Work?
Bitcoin is able to work as a decentralized peer-to-peer currency because it stores every single transaction ever made in the history of the network. The speed at which nodes and miners can validate transactions puts a bottleneck on the network’s scalability at roughly one megabyte of transaction data every 10 minutes. This is where the Lightning Network comes in.
When Satoshi Nakamoto created Bitcoin, his goal was to create a decentralized, peer-to-peer, digital cash. But with the current state of the network, there is no way that Bitcoin, on its own, can scale to compete with existing payment solutions — Visa, a commonly cited example, can process 65,000 transactions per second, while Bitcoin’s transaction throughput is currently closer to 4.6 transactions per second.
Lightning was originally designed to solve this problem for Bitcoin, but it can be implemented on other blockchains as well. The Lightning Network is built around two-way payment channels, which are a way of combining many small transactions into a single, large transaction through cryptography.
Let’s say that two parties know that they’re going to transact with each other frequently, so they don’t want to continually pay network fees or wait 10 minutes for a transaction to settle. Instead of broadcasting transactions on a node, a payment channel is created between the two parties (let’s call them Alice and Bob) using a multisignature address on the blockchain, which is signed by the private keys of both parties. At least one of the parties needs to deposit Bitcoin into the address. This address essentially works to put the funds in escrow, only allowing them to be unlocked once both parties agree. It operates as a balance sheet that will record future transactions.
Since the payment channel has been established, Bob can send Alice 0.01 BTC without needing to be validated by a miner on the main chain. Alice and Bob cryptographically sign each transaction, which works as a receipt against the funds in the wallet. As long as there are enough funds in the wallet, Alice and Bob can send thousands of transactions between them nearly instantly because these transactions are occurring off the main chain. Once Alice and Bob decide to close the channel, the payment history is calculated into a single transaction and settled onto the Bitcoin network.
Lightning Network is a bitcoin cache that allows you to delay settlement in order to save on fees and make instant payments. Bitcoin cache is Bitcoin. 😎
— Jameson Lopp (@lopp) December 29, 2017