How does Bitcoin's Lightning Network work?

Author: Baize Research Institute

On October 5, 2016, the first lightning transaction on the Bitcoin testnet was completed by the engineering team at blockchain technology company BlockStream. Dr. Decker stated in an interview, "This is an important milestone for the Lightning Network. This is the first time we have established a channel on a real blockchain, with real latency and block rates, which includes invoicing, lightning transactions, and item delivery, where the payment is routed from one node to another through a third node."

After five years of technological upgrades and developments, according to data from TXStats, on October 2, the Bitcoin capacity on the Bitcoin Lightning Network surpassed the milestone of 3,000 bitcoins. Since breaking through 1,500 bitcoins in June, the Bitcoin capacity of the Lightning Network has more than doubled.

With increasing major events in Bitcoin adoption, such as El Salvador enacting the Bitcoin law and Twitter allowing users to tip with Bitcoin, the Lightning Network has demonstrated its ability to expand both the number of channels and Bitcoin capacity during sharp increases in transaction activity. Since the beginning of the year, the amount of Bitcoin held in Lightning channels has nearly doubled.

How Does the Lightning Network Work?

The Lightning Network operates as a second layer on top of the Bitcoin blockchain and is directly anchored within it. It can process millions of transactions per second cheaply and efficiently.

In the white paper of the Lightning Network, the authors describe their vision of how the Lightning Network can scale Bitcoin into a more efficient and faster payment network.

The white paper states, "With these micropayment channels, Bitcoin can scale to billions of transactions daily." "Sending many payments within a given micropayment channel allows one person to send a large amount of funds to another in a decentralized manner. These channels are not independent trusted networks built on top of Bitcoin; they are real Bitcoin transactions."

Below, we will illustrate how the Lightning Network works by comparing it to a bar.

When you consume at a bar, you need to swipe your card and settle the bill each time you order a beer.

Alternatively, you can save time, effort, and costs by consolidating all the beer bills at the end of the party and settling them at once. This method is similar to how the Lightning Network operates.

Now, imagine your bar operates on the Lightning Network.

On the Lightning Network, when you want to start a transaction, you will open a payment channel, which is similar to a running tab (beer bill). Therefore, when you start buying beers, these transactions are recorded on the payment channel, just as they would be recorded in the bar's bill book. However, what is transferred on the payment channel is not just the bill; it is real Bitcoin, so you are paying for your beers in real-time with every tip. These transactions are simply not recorded on the blockchain. Bitcoin is transferred between you and the bar through the payment channel.

When you finish your consumption and close the payment channel, the final settlement of the Bitcoin held by both parties will be broadcast to the blockchain, completing all transactions.

How Does the Lightning Network Scale the Bitcoin Blockchain?

As we discussed earlier, the Lightning Network operates separately from the blockchain, but it is still anchored to it. The Lightning Network is where transactions occur, while the blockchain is where these transactions are finalized.

Therefore, in your bar consumption, there are actually only two real transfers on the blockchain. The first transaction occurs when you fund and open the payment channel with Bitcoin, and the second occurs when you close the payment channel. However, between these two transactions, you can make an unlimited number of transfers within the channel on the Lightning Network.

By conducting those potential transactions on the Lightning Network, we can alleviate the burden on the entire blockchain, increasing transaction rates while keeping transaction fees low.

However, you might think that establishing payment channels with hundreds of businesses/companies would be cumbersome, but this is where the Lightning Network truly shines. You do not need to open a direct payment channel with someone to make a payment. You can pay individuals and businesses through intermediary channels on the Lightning Network.

How Do Intermediaries in the Lightning Network Work?

Suppose you take your friend Bob to the bar. Bob has an open payment channel with the bar, but the bar provides one for you. Bob can still pay the bar bill through your payment channel. This is like Bob buying beers on your behalf and settling the bill with you.

This is why the Lightning Network is so scalable. It finds the fastest path between two parties to record everyone's transactions and ensures that everyone receives the corresponding Bitcoin. Even if there is no direct payment channel between two users, they can still pay each other through one or several other intermediaries on the Lightning Network, where the intermediary forwards your payment to the recipient. Therefore, instead of establishing hundreds of payment channels between all the businesses/companies you want to patronize, you only need a few intermediaries, and the Lightning Network will automatically handle the rest.

So, this is the Bitcoin Lightning Network. It combines speed, security, and low fees, making Bitcoin scalable to a global audience and one of the most efficient payment networks.