Chapter 6: The Lightning Network as a Second-Layer Solution

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Scaling Challenges on the Bitcoin Blockchain

Bitcoin’s blockchain faces a significant hurdle: scalability. With new blocks mined every ten minutes, the network can handle a few hundred to a few thousand transactions. However, when we consider transactions per second, Bitcoin’s throughput is limited to a mere four to seven, a far cry from the thousands processed by Visa’s payment network. The distinction lies in the nature of these transactions—Bitcoin’s on-chain transactions ensure finality, whereas Visa’s centralized system confirms transaction conditions, with actual settlement taking days. For instance, Visa is actually a second-layer solution built on Fedwire in the US, for interbank transaction settlements.

Yet, to integrate Bitcoin into daily transactions, a solution was crucial. Enter second-layer solutions, building new frameworks atop the Bitcoin blockchain, notably the Lightning Network.

1. Decoding the Lightning Network

Understanding Lightning is often likened to a café visit. When enjoying drinks all evening, you can order continuously without immediate payment. The waiter maintains a tab that is settled at the night’s end.

The Lightning Network operates through channels between two nodes. For instance, Simon can open a channel with Linda and deposit 200,000 Sats on his end. A Bitcoin comprises 100 million Sats (Satoshis), but the Lightning Network, optimized for smaller payments, typically uses Sats.

Simon’s channel now holds 200,000 Sats as outgoing liquidity, lacking incoming liquidity to receive payments. When Simon pays Linda 50,000 Sats, these Sats shift within the channel, residing on Linda’s end. The channel’s status updates—Simon holds 150,000 Sats, and Linda possesses 50,000 Sats. Upon closing the channel, this is recorded on the blockchain.

Opting to keep the channel open, Linda can later transfer 20,000 Sats back to Simon. Upon channel closure, an on-chain settlement occurs. Linda receives 30,000 Sats in her wallet, while Simon reclaims 170,000 Sats from the 200,000 locked at the channel’s outset.

The Network Effect: Interconnected Channels

The Lightning Network thrives on interconnected channels. If Simon seeks to pay Bart but lacks a direct channel, Linda can facilitate the transaction. With a channel to Bart and adequate liquidity, Linda temporarily receives the Sats before forwarding them to Bart.

Lightning nodes determine transaction paths, enabling near-instant global payments. This network facilitates millions of transactions per second, unveiling its tremendous potential.

2. Joining the Bitcoin Lightning Network: Your Options

Participating in the Lightning Network offers multiple pathways. You can engage by setting up your own node or opt for user-friendly apps like Muun Wallet or Wallet of Satoshi, eliminating complex technicalities. These applications handle incoming and outgoing liquidity, streamlining the process. Begin by transferring Bitcoin to your chosen Lightning app via an on-chain transaction. Within the app, allocate the desired amount of Sats to your Lightning wallet and commence transactions hassle-free.

Several exchanges now facilitate Lightning transactions, enabling direct transfer of Sats from the exchange to your Lightning wallet. To receive payments, generate an ‘invoice’ specifying the desired Sats amount. This generates a QR code scannable by the payer through any Lightning-supported app.

Beyond dedicated Bitcoin apps, Lightning is making headway into larger payment apps. In early 2022, Jack Dorsey’s Block announced Lightning support via the popular Square app. The emergence of the Strike app by Jack Mallers is widely anticipated, touted as the potential ‘killer app’ driving widespread Bitcoin network adoption. Twitter, leveraging Strike’s API, has integrated Lightning payments into its tipping feature.

Lightning’s Rising Adoption

In the Lightning Network’s early days in 2021, around 8,300 nodes were active. By mid-2022, this figure soared to over 17,000 connected nodes, signifying a staggering 100% growth in just one year.

Moreover, the volume of Bitcoin within the Lightning Network has surged significantly. In mid-2022, total liquidity surpassed 4,500 BTC, valued at over $100 million. A remarkable leap from January 2021 when liquidity stood at only 1,058 BTC, indicating a tripling of Bitcoin liquidity in just a year. This exponential growth underscores the accelerating acceptance and utilization of Lightning across the Bitcoin ecosystem.

3. Lightning Network advantages: A Game-Changing Paradigm in Payment Systems


Embracing an Open Network

The Lightning Network is an open platform, accessible to all globally. Unlike closed payment systems such as Visa, Mastercard or local payment options such as iDEAL in the Netherlands, Lightning fosters universal connectivity. With Bitcoin Lightning wallets like Muun or Wallet of Satoshi, users can seamlessly transfer funds worldwide, transcending app-specific barriers. It’s an open-source software inviting innovation, allowing individuals to build their applications leveraging APIs from Strike or Block.

Cost-Effective Transactions

Traditional transaction processes entail considerable expenses. Retailers typically invest in costly payment terminals, along with subscription fees and additional transaction charges. Credit card payments attract exorbitant fees, ranging from fixed amounts to a percentage of the transaction, often escalating to 1.5% or more.

Enter Lightning and Jack Mallers’ Strike app, heralding a paradigm shift. With a meager 0.05% fee through the Strike app, transactions are simplified and substantially cheaper. A supermarket processing 100 Visa card transactions at €200 each could incur €300 in fees, contrasting Strike’s charge of a mere €0.1 per transaction. The potential savings for large companies are staggering, reaching thousands of euros monthly.

Instant Settlements

In the traditional system, Visa payments demand fees for ‘finality’ and settlements, passing through multiple intermediaries and institutions, resulting in high fixed costs. Conversely, Lightning offers nearly cost-free settlements. With Strike, users effortlessly link their bank accounts, converting euros to Bitcoin for instantaneous cross-border transactions. The process—from conversion to transfer—takes mere seconds, eliminating the usual delay of days, especially during weekends or holidays.

Moreover, Strike’s capability to convert currencies seamlessly ensures swift international transactions. In practice, while this method is still evolving, Strike’s integration of dollars in the US hints at future potential for easy global money transfers.

When paying in a store, Strike will take your euros or dollars from your account, immediately convert them into bitcoin, send them via Lightning to the correct recipient, where they are converted back into euros or dollars. This entire process takes just a few seconds and because Bitcoin is a super liquid market trading 24/7, such payment can be made at any time.

The Lightning Network, spearheaded by innovations like the Strike app, promises a seismic shift in payment systems. Its open nature, cost-efficiency, and lightning-fast settlements not only revolutionize payments but also pave the way for a more inclusive, accessible, and efficient global financial landscape.

4. Entry Hurdles and Adoption

Embracing Lightning Network for daily transactions demands a leap into digital wallet usage. Wallets like Muun or Wallet of Satoshi, safeguarding your keys, grant you full control but also carry the risk of losing access if forgotten. Custodial wallets, a more forgiving option, allow password retrieval through the platform.

However, getting Bitcoin into these wallets poses a challenge. Most exchanges lack Lightning support, necessitating on-chain transactions—often costly. Yet, promising developments like Kraken’s Lightning withdrawals hint at wider accessibility.

El Salvador’s adoption of Lightning wallets for everyday transactions illustrates a promising trend.

Regulatory Landscape and Uncertainty

Regulatory authorities face challenges in monitoring self-established Lightning wallets, diverging from centralized banking norms. With no central control, eradicating such wallets remains beyond their scope. However, concerns about anonymous wallet use are prompting governments to consider stringent regulations, potentially requiring identification and registration of wallets, notably affecting exchanges.

Regulators might target apps like Wallet of Satoshi or Strik’s API usage, influencing compliance mandates. Strike’s unique structure allowing direct Bitcoin purchases requires robust KYC protocols, possibly inviting regulatory scrutiny akin to challenges faced by major platforms like Binance.

5. Navigating Beyond Lightning: Exploring Alternative Solutions

While Lightning stands out, other Bitcoin-based projects like Liquid sidechains or Stacks offer different solutions. Additionally, centralized entities might introduce their layers, as banks integrating Bitcoin for their clients exemplify. Although such systems may offer user-friendly interfaces, they entail closed systems disliked by purist Bitcoin enthusiasts.

Moreover, beyond second layers, third-layer applications like stablecoin integration atop Lightning signify evolving possibilities for Bitcoin’s diverse applications.

Despite its transformative potential, Lightning Network confronts entry barriers and regulatory uncertainties. While offering unparalleled speed and cost-effectiveness, regulatory challenges and user-adoption hurdles need addressing for its widespread implementation. Furthermore, exploring alternative layers and solutions could diversify Bitcoin’s applications beyond Lightning’s scope.