How the Lightning Network works, what makes it so fast and cheap, and what it might mean for cryptocurrency.
The bitcoin Lightning Network is a new system designed to help solve bitcoin’s problem of high fees and slow transactions. You can think of it as a kind of relay network to bounce money between people as needed, without necessarily going on the blockchain.
Essentially the bitcoin blockchain is a bank vault where money is held, while the Lightning Network is a payment network that’s connected to the bank vault.
How the Lightning Network works
The picture below shows some of the test nodes active on the Lightning Network mainnet at the time of writing. You’ll notice that all of the nodes (with the unusual exception of that one called Satoshi’s Vision for some reason) are connected to at least one other node.
This is because you can’t be a node without having at least one connection, and you can’t use the Lightning Network without being a node.
When you set up a Lightning Network node, you will need to set up a connection with at least one other node. Either your node, or a node you’ve connected to, will need to put at least some amount of bitcoin into the connection.
This is because the connections are actually multisignature cryptocurrency wallets. Multisignature wallets are like shared bank accounts, in that the contents can be accessed by more than one person. In this case, those people are two connected nodes. Lightning Network smart contracts keep track of how much money in the connection belongs to each party and make sure people can only access their own money.
When a Lightning Network node is first set up, the connection’s details, including its wallet address and bitcoin balance, are transmitted to the main bitcoin blockchain where they securely join the ledger. This is essentially a snapshot of a new node and its connections when it’s first created. A second snapshot is sent to the blockchain when a Lightning node is closed.
Transactions can be bounced along between as many nodes as needed, so you don’t need to have a direct connection to send money to someone. This will be facilitated through hubs like those you can see in the picture.
Using your node
Each transaction is signed by the private keys of both nodes to verify that it actually happened and was approved. This serves as a record of transactions and source of truth for the network. The nodes will not need to broadcast any information to the blockchain until a node is closed, at which point the closing balances are put on the blockchain as a kind of update to the original snapshot.
Almost all of this will happen automatically. Despite the creative underlying system, it should feel like a normal payment network.
Bob wants to send money to Jane on the Lightning Network, so he opens a node and connects it to Jane’s node. He puts 0.5BTC into the connection. This information goes on the blockchain as the first snapshot. If it was written in words the information would say something like “Bob has 0.5BTC and Jane has 0BTC”.
The same information also shows up on the Lightning Network, telling it who the money belongs to. Right now Bob can access 0.5BTC in the wallet, while Jane cannot access any.
Then Bob sends 0.25BTC to Jane. But instead of going to all the trouble of actually moving money around, or sending information to the main bitcoin blockchain, the Lightning Network simply updates to say “Bob has 0.25BTC and Jane has 0.25BTC.”
This is what makes the Lightning Network so nimble. It doesn’t actually need to transfer information to the blockchain except when the bank vault itself is accessed, which only happens when a node is opened, closed or when someone wants to “top up” their Lightning account.
Other than this, payments can happen at the speed of data and be completed in a fraction of a second. It doesn’t actually move money, it simply changes who can access the money that’s already there, and how much they can access. In the digital world, this is the exact same thing.
But as you might have realised, this means the system needs to be full of money. A connector wallet might not be able to bounce along a transaction if it doesn’t have enough money to pass it through. This is a downside, but the nature of the network means it might not be as crippling as it sounds.
Pros and cons of the Lightning Network
The main benefits are:
- Micropayments are possible. Since bitcoin got popular it’s been almost impossible to send small amounts on the bitcoin network because the fees are so high.
- Payments are almost instant. The money will typically be “sent” and available in a fraction of a second.
- Privacy and anonymity. A side-effect of its off-chain design, and the way transactions are bounced around decentralised nodes, is that Lightning Network transactions are largely anonymous and untraceable. Unless someone goes out of their way to save them, the details of Lightning Network transactions will disappear when a node is closed.
But the main downsides are:
- Online only. You won’t be able to send money to someone if their node is offline.
- Centralisation. The necessary hub system means a certain amount of centralisation is inevitable. A small handful of nodes might end up handling the majority of transactions on the network, which could be a point of failure.
- Too much privacy and anonymity for some purposes. Because it’s almost impossible to effectively track Lightning transactions, it might simply be incompatible with applications like gambling or other situations that require KYC-compliant transactions.
And thirdly, the connections need to be loaded with bitcoin. If you try to send too much money all at once, the system might have trouble finding connector wallets with enough money in them to facilitate your transaction. When this happens it might hit a dead end. You won’t lose the money, but it might be MIA for a few hours.
This is why the Lightning Network is, by necessity, geared towards small and micro transactions equivalent to just a few dollars or cents. There should easily be enough bitcoin in the network pipes to conduct those kinds of small transactions.
The fee structure also gears the network towards small transactions.
How much are the Lightning Network fees?
The Lightning Network will still have fees, although they’re expected to be only around a fraction of a percent of the transaction amount. These fees are paid to the other nodes that your transaction travels along, as an incentive for them to keep nodes online and functional (ie loaded with enough bitcoin to pass transactions through).
Users realistically won’t have a connection with everyone they want to pay, and new connections need to be recorded on the blockchain so they can’t really be opened on the fly too well. As such, these hubs are most likely going to be an important element of the network.
Other than those transaction fees, there will also be the costs of transmitting information to the main blockchain, as a regular bitcoin transaction, when opening, closing or topping up a connection.
How do you put money into the Lightning Network after opening a node?
Good question. This essentially involves sending money to your Lightning Network address like a normal cryptocurrency transaction. You could simply load it up with bitcoin, but the fees for doing so might still be higher than you want, and it might take longer than you want.
The good news is that bitcoin isn’t the only Lightning Network compatible coin. It just happens to be the first, and one of the coins that might benefit the most. There will most likely also be a separate Litecoin blockchain Lightning Network, a Stellar Lumens Lightning Network and others.
The non-bitcoin Lightning Networks can probably be topped up with negligible fees, even when using the main blockchain. But to duck the bitcoin blockchain fees, people might start using intermediaries who have both Litecoin and bitcoin lightning nodes.
How will the Lightning Network change cryptocurrencies?
It’s impossible to say with certainty what kind of impact the Lightning Network will have on cryptocurrencies and their prices.
The two most extreme predictions on either end might be that it will either make or break bitcoin.
- Make – With an effective payment network in place bitcoin might become the king of internet payments, and render other “fast” coins useless.
- Break – Its complexities and downsides mean that even with the Lightning Network bitcoin still won’t be the ideal payment option. Having seen bitcoin’s “final form” and finding it underwhelming, people still seek out alternatives that are even faster, cheaper and more functional than the Lightning Network.
Factors to bear in mind include:
- The Lightning Network is bigger than bitcoin. It crosses a range of networks, and will probably enable some functions that are hard to anticipate, with effects that are impossible to predict.
- The Lightning Network doesn’t solve all of bitcoin’s problems. It won’t be usable everywhere, can’t be completely divorced from the base blockchain, and will inevitably still be slightly slower and more expensive than close alternatives like the Litecoin Lightning Network.
However, a lot of businesses invested heavily in bitcoin payment systems before it ran into scaling problems. With the Lightning Network up and running they might return quickly. Third party bitcoin payment platforms that hold user coins on their own wallets may be able to act as nodes and offer a near-seamless bitcoin Lightning Network experience for their users.
For example, providers might quickly start offering bitcoin debit cards that interface with the Lighting Network to conduct transactions. Bitcoin might become a widely used payment system much quicker than one might expect after the Lightning Network goes live.