What Is The Lightning Network, And Why Is It Important?

Apr 10, 2023

To answer that question, we need to start with Bitcoin, and why is Bitcoin important? Bitcoin is a digital currency that isn't issued by a government or bank; in many ways it's similar to a digital version of gold. It's a technological breakthrough that has been running for well over a decade now. But while some touted Bitcoin as an ideal payment system, which allowed people to transact anywhere instantly, privately, and for free, Bitcoin has many technical limitations that hinder its widespread use. The Lightning Network is a network of computers that lets people transfer their bitcoin more quickly, and with much lower fees. The analogy between Bitcoin and gold isn't perfect, but there are similarities in how they are used and how things might turn out for Bitcoin without the Lightning Network.

As metals go, gold has historically been considered as a store of value by some. It doesn't degrade, has a distinct look different from other metals, is easy to work with and is scarce enough that you can carry enough of it to buy a house.  But it's not perfect. Weighing it precisely is inconvenient, and determining its purity much more so. For these reasons people used coins, where the hard to forge mark of a king let people trade without weighing or testing the metal itself. Eventually goldsmiths became banks, issuing paper notes that could be redeemed for gold, which were much more convenient to circulate. Until about 50 years ago, most national currencies were "backed" by gold, meaning that the paper currency itself was a promise that the government would redeem their currency for gold. Gold isn't widely used as a currency today, and the history of entities debasing gold-backed currency and breaking promises to redeem paper currency for gold goes back thousands of years.

Some could say "Well it's not gold's fault that everyone put their gold in the bank and used paper notes that represented the gold instead!  Of course paper notes aren't scarce, and those promises can be broken." But you can see it as a failure of gold itself: it's too hard to carry and verify. 

We've seen a similar arc play out with Bitcoin over the much shorter time it has been around.  Bitcoin exists electronically, so to send and receive bitcoin all you need is a computer with bitcoin software (a bitcoin node), and an internet connection. This node performs all the verification that the bitcoin you're receiving is real, hasn't been tampered with, and obeys all the rules, assuring you that when you try to spend it everyone else who uses bitcoin will accept yours.  

But there are some downsides. Running a node can take up a lot of space on your computer, the transfers can take minutes to hours to confirm, and there can be substantial transaction fees paid to the bitcoin miners. For these reasons as well as others, people have been sending their coins to exchanges and other places that offer a convenient place to store and transfer coins. Just like with gold, these services don't always give the bitcoins back.  We’ve seen recent cases where people who thought they had bitcoins on an exchange learnt that wasn’t the case as the exchange didn’t have the bitcoins either. This has caused much disruption and distress. Bitcoin custodians can offer faster transfers, lower fees, and the convenience of a website, but they don't offer the security, scarcity and digital verifiability that make bitcoin unique.

The Lightning Network brings many of the advantages and conveniences of Bitcoin custodians while keeping the security and independence of directly holding bitcoin.s

The building block of the Lightning Network is a payment channel - an amount of bitcoin that is shared between two people such that they both need to agree how and where to spend it. These two people can continually, privately and instantly negotiate who owns how much of the bitcoin in the channel. A channel with 10 coins could be evenly split, where both people agree that they both own 5 coins one second, and the next they could change that to one side owning 9 coins and the other only owning 1. Importantly, this agreement on ownership is not a promise: the people have not agreed to transfer the bitcoin in the channel on demand -- they have each already signed and given their counterparty a way to "close" the channel and take the amount they own without any further interaction. This makes a bitcoin you hold in a payment channel much more like a bitcoin you own outright, and unlike one held for you by a custodian.

Once people have established payment channels, they can route payments through these channels; the Lightning Network is a network where the links are bitcoin payment channels. If Alice is connected to Bob with a payment channel, and Bob has a payment channel with Carol, Alice can route a payment to Carol through Bob.

Just like within a single payment channel, and Bitcoin in general, payment forwarding is not based on trust. Bob doesn't promise to forward the money Alice pays him on to Carol. The software and cryptography makes sure that Bob can only gain bitcoin in his channel with Alice if he loses money to his channel with Carol. From Alice's perspective, the worst Bob can do is fail to forward the payment to Carol; he can't accept Alice's bitcoin and keep it for himself.

With more people using the Lightning Network, each new user has more options of where to pay with much faster speed and lower fees than standard bitcoin transactions. There is a significant opportunity for businesses and companies if use of the Lightning Network is adopted at scale.

How Is the Lightning Network Transforming How People Use Bitcoin?
The Lightning Network solves the problem of limited bitcoin throughput on the blockchain and drastically reduces transaction fees for small payments.
What Is A Lightning Network Channel?
A Lightning Network channel is a two-way connection between two parties that enables them to exchange funds.
What Does The Lightning Network Do?
The Lightning Network has the potential to improve the usability and scalability of Bitcoin.