Lightning Network: What It Is and How It Works

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 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.

Understanding the Lightning Network

At first, Bitcoin was intended to be a decentralized payment system in which the users could remain anonymous and access it from anywhere. It became popular enough that the blockchain couldn't handle the number of transactions occurring.

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, throughput, and costs.

To counter slow transaction speeds and excessive energy use, developers created cryptocurrency layers. The first layer is the primary blockchain. The layer "on top of" the first one is the secondary layer and complements the layer below it by adding functionality. The Lightning Network can also be used to handle other types of off-chain transactions involving exchanges between cryptocurrencies.

What Issues Does the Lightning Network Try to Address?

Some issues the Lightning Network attempts to correct are:

• Sluggishness in confirming transactions: Those who pay higher fees have their transactions processed first, which makes lower-paying users wait longer.
• High energy costs: The energy necessary to propose a block of transactions through a competitive process is enormous, making 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 proper recipients.
  

The Lightning Network allows users to open channels so that they can send multiple transactions to each other 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. 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 closed-channel fraud. This happens when a user closes a channel (logging off) and goes offline before the transaction completes. 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.

Once the two parties settle the bill, they must record a closing transaction for the agreed amount on the blockchain, including 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) can all be hacked.

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.

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 cheaply. It is a solution designed to solve issues on the Bitcoin blockchain through 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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