Authors: Dr. Jonas Gross, Jonathan Knoll, Yannic Fraebel
Introduction
The Bitcoin Lightning Network is becoming more and more popular. The spread of Lightning is progressing relentlessly: there are now more than 4,800 bitcoins in the Lightning system, equivalent to more than USD 90 million. In addition, there has been an increase in institutional activity around Lightning. For example, Lightning Labs, a major contributor to the Lightning protocol, received USD 70 million in Series B funding earlier this year. The number of companies offering Lightning-related services is proliferating rapidly. This series of articles will look at the Lightning Network's fundamental aspects. The focus will be on questions around its motivation, functionality, and use cases, as well as its current importance and the future of Lightning. The first part of the series addresses why the Lightning Network is needed.
Bitcoin as a global payment system?
Bitcoin offers numerous advantages as a decentralized payment system through which money can be sent worldwide without intermediaries. Chief among these is the low entry thresholds for participants: any citizen in the world with an Internet-enabled device can use the bitcoin protocol. No one can be excluded, which positively impacts financial inclusion. Moreover, Bitcoin represents a scarce digital asset, a kind of "digital gold." Each bitcoin can be divided into 100 Million satoshis, just like you can split one euro into 100 cents. Unlike fiat currencies, according to the Bitcoin protocol, the money supply is limited to roughly 21 million bitcoin. Thus, a debasement via dilution of Bitcoin is impossible.
Despite the advantages mentioned, the technology’s current state also has limitations. For transactions via the Bitcoin blockchain, the significant decentralization of the network comes at the expense of transaction throughput, i.e., the number of transactions that can be carried out per second. A maximum of seven transactions per second ("on chain") can be confirmed via the Bitcoin Network.
To function as a payment system, this low transaction throughput is insufficient. Established payment service providers such as Visa or Mastercard enable several thousand transactions per second and thus scale much better - even if being completely centralized. Transactions on the Bitcoin Network usually need longer time windows until they are confirmed ("mined") and are therefore not suitable for everyday payment transactions. Another limitation is small payments via Bitcoin. Each transaction incurs a fee based on its storage size. The more storage used, the more expensive the payment. On average, a transaction, regardless of volume, today costs approximately 1 USD. At times of increasing demand, such as in 2017, transaction fees have peaked at more than 60 USD. For large payments, transaction fees may seem relatively cheap; however, small payments are usually uneconomical due to the relatively high transaction costs.
Lightning addresses Bitcoin's disadvantages
The goal of the Lightning development is to make Bitcoin suitable for everyday use as a means of payment. The top priority is to increase payment throughput without centralization, which is the basis of payment networks, such as Visa or Mastercard. More specifically, this means more payments at mostly cheaper rates. While Bitcoin's whitepaper was published by Satoshi Nakamoto as early as 2008, the idea of the Lightning Network dates back to 2015. The first implementations began in 2016. In 2018, the first users started to use Lightning implementations. Since then, the technology and the network have evolved rapidly. However, despite a heavy transaction volume and recent progress in adoption, it is still in its infancy in 2022.
How does Lightning solve the problems of low transaction throughput and relatively high transaction fees? Not all payments are written to the blockchain (i.e., "on-chain"). Most payments are made to each other "off-chain," and only in extreme cases or when a financial relationship between two network participants is terminated are they written to the blockchain (“settled”). As a result, payments from users can be processed in real-time and at a low cost. Users who send money via Lightning do not have to wait for mining; payments are processed directly and finalized immediately.
How does the Lightning Network work in general?
To understand how the Lightning Network works, consider the following real-world example. Assume you are going to a bar with a few friends to have a fun evening. You want to invite them for drinks, but it is too burdensome for you to pay for every drink separately. Thus, you leave your credit card with the bartender to open a tab. Every time you or one of your friends orders a drink, the bartender keeps a tab. At the end of the evening, the bartender closes the tab and gives you the final bill to conduct the payment. Such bar tab payment is a common practice in the US and UK.
The bar tab example is similar to the Lightning Network: Individuals send IOUs to other individuals or merchants via so-called Lightning Channels (off-chain). They open a ‘payment channel’ just like one would ‘open a bar tab’ with a bartender. Theoretically, the two parties can exchange an infinite amount of IOUs. At some point, the payment is finally settled in bitcoin (on-chain). Note that this example is somewhat incomplete since the Lightning Network can do much more: It does not require trust in the other party. You can also make payments to people with whom you do not directly maintain a payment channel via so-called routing. You can learn/read more about these topics in future articles!
Conclusion
The Lightning Network is the next evolutionary step of Bitcoin. Bitcoin enables global transactions without intermediaries, but settling all payments via the Bitcoin Blockchain has limitations. Lightning can significantly increase payment throughput, which is necessary for Bitcoin to be widely used as a payment system. With Lightning, small payments can be made at a fraction of the cost, laying the foundation for an entire micropayment economy. We will discuss how exactly the Lightning Network works in detail in the second part of our article series.
About the authors
Dr. Jonas Gross is Head of Digital Assets and Currencies at etonec GmbH. Jonas holds a Ph.D. in economics from the University of Bayreuth (Germany), and his main fields of interest are central bank digital currencies, stablecoins, cryptocurrencies, and monetary policy. Further, Jonas is Chairman of the Digital Euro Association (DEA), co-host of the German podcast "Bitcoin, Fiat, & Rock'n' Roll," and member of the Expert Panel of the European Blockchain Observatory and Forum. You can reach Jonas via jonas@etonec.com.
Jonathan Knoll is Founder and Managing Director at etonec GmbH. He has more than 25 years of experience in the payment & banking and blockchain industry working for innovative companies such as Sun Microsystems, PayPal/eBay, and Libra/Diem, where he was Head of Strategic Partnerships. At etonec, he is excited about building solutions at the intersection of crypto, payments & banking, and regulation. You can reach Jonathan via jonathan@etonec.com.
Yannic Fraebel is the Managing Director of App-Learning GmbH. Yannic holds a Master's degree in Information Systems from the Munich University of Applied Sciences (Germany). He wrote his thesis about “Lightning Service Provider as an alternative to neobanks?”. His main interests lie in bitcoin, cybersecurity, and economics. Also, Yannic is an Advisor at Blockchain Founders Group AG (BFG) and a former mentor of the DeFi Talents Program. You can reach Yannic at yannic@app-learning.com.
The authors appreciate the great support and feedback from René Pickhardt and Denis Scheller. Their insights and comments were essential to making this article reality.