Exploring the Lightning Network, the Leading Layer 2 of Bitcoin

Previously, we also discussed the Bitcoin Layer 2 ecosystem. Most Layer 2 solutions primarily rely on transferring liquidity from other networks to the Ethereum ecosystem to participate in various DeFi activities. However, these so-called "withdrawal bridges" often use multi-signature mechanisms, which introduce a certain level of trust when handling assets. Users cannot guarantee that they can withdraw their assets unconditionally at any time. This lack of assurance makes many Bitcoin holders unmotivated and uneasy about transferring BTC assets to the potentially risky Ethereum environment, as the security of assets is a prerequisite for ensuring all profits.

In this context, the Lightning Network, as a Bitcoin Layer 2 solution, is particularly important. The Lightning Network aims to enhance the scalability and transaction speed of the Bitcoin network. Unlike "bridges" that rely on multi-signature mechanisms, the Lightning Network creates off-chain payment channels, allowing users to conduct fast and low-cost transactions without transferring liquidity to other networks. For many Bitcoin holders, the Lightning Network provides a secure and efficient way to make everyday small payments without the risk of transferring BTC assets to other blockchain networks. The emergence of the Lightning Network injects new vitality into the Bitcoin ecosystem and offers more possibilities for DeFi and other application scenarios.

What is the Lightning Network?

Concept

The Lightning Network can be seen as a prototype of the currently popular Rollup technology, with the core idea of moving the transaction execution layer off-chain to improve execution efficiency; the final state is then written back to the blockchain during final settlement. By allowing users to transact off-chain without requiring block confirmations on the blockchain, the Lightning Network significantly enhances the transaction speed and efficiency of the Bitcoin network. This mechanism helps reduce transaction fees and improves the overall scalability of the network.

As a second-layer protocol, the Lightning Network enables users to create payment channels on the Bitcoin network. It operates on top of the Bitcoin blockchain and uses multi-signature wallets to facilitate the creation of off-chain payment channels. Due to Bitcoin's lack of a smart contract system like Ethereum's, the Lightning Network utilizes Bitcoin's limited scripting capabilities to construct a series of one-to-one "state channels," connecting these state channels into a payment network to achieve a unique form of fast payments, similar to "Rollup." The design goal of the Lightning Network is to address the scalability issues of the Bitcoin network while maintaining decentralization and security.

Development Path

The concept of the Lightning Network was first proposed by Joseph Poon and Thaddeus Dryja in 2015, who described this innovative solution in a white paper to address the scalability issues of the Bitcoin network. In 2015, Joseph Poon and Thaddeus Dryja published the Lightning Network white paper, outlining the idea of improving Bitcoin transaction efficiency through off-chain payment channels. From 2016 to 2017, early implementations of the Lightning Network protocol began to emerge, with multiple development teams and companies such as Lightning Labs, ACINQ, and Blockstream involved in its development. In 2018, the mainnet version of the Lightning Network officially launched, and early users began testing and using this technology.

From 2019 to 2020, the Lightning Network gradually matured, with a rapid increase in the number of nodes and channels, and network capacity continued to grow. More and more wallets and services began to support Lightning Network payments. After 2021, the Lightning Network entered a rapid development phase, with an increasing number of merchants and applications integrating Lightning payments, and the ecosystem continued to expand.

It can be said that the Lightning Network is to Bitcoin what Visa is to currency. In 2022, there were also several large financing rounds in the Lightning Network space, with top institutions such as a16z and Paradigm participating in related project investments. For example, in April 2022, Lightning Labs, a company focused on Bitcoin operations, completed a $70 million Series B funding round led by Valor Equity Partners. In May of the same year, Lightspark, a Bitcoin Lightning Network company founded by Meta's cryptocurrency head David Marcus, completed a funding round led by a16z and Paradigm. In September 2022, the crypto payment application Strike, built on the Bitcoin Lightning Network, announced the completion of an $80 million Series B funding round.

Advantages and Problems Solved

The Lightning Network offers a range of significant advantages through its unique off-chain transaction mechanism and addresses some key issues in the Bitcoin network.

• Convenience for Small Transactions: The Lightning Network allows users to make payments using the smallest unit of Bitcoin, "Satoshi," meeting the needs of everyday small purchases. In traditional Bitcoin transactions, small payments are often not cost-effective due to high fees, whereas the Lightning Network significantly reduces the costs of these transactions, making small payments more convenient.
• Reduced Transaction Costs: In the traditional Bitcoin network, transaction fees are around $2, and during the market peak in 2021, they exceeded $60. However, through the Lightning Network, the fee for a $100 transaction is only about 1 cent, making it extremely cost-effective for everyday small payments and significantly lowering users' transaction costs.

Bitcoin transaction fees, data source: https://bitinfocharts.com/comparison/bitcoin-transactionfees.html

• Accelerated Transaction Processing Speed: The current Bitcoin network can process a maximum of 7 transactions per second, and network congestion often leads to delays in transaction confirmations, affecting user payment experiences. The Lightning Network can theoretically handle millions of transactions per second, greatly enhancing transaction speed, ensuring users can complete payments instantly, and optimizing the overall payment experience.

How It Works

The Lightning Network enables fast and low-cost Bitcoin transfers through off-chain payment channels. Here is a brief overview of its operation process:

Creating a Payment Channel: Two parties (for example, Alice and Bob) create a multi-signature address on the Bitcoin blockchain and each deposit a certain amount of Bitcoin. This operation needs to be conducted on the blockchain and incurs the corresponding transaction fees.

Conducting Off-Chain Transactions: Once the channel is established, both parties can conduct multiple off-chain transactions within the channel. These transactions are not immediately recorded on the blockchain but update each other's balances. After each transaction, both parties sign a new transaction state.

Settling the Channel: Either party can close the channel at any time by broadcasting the last signed transaction state to the blockchain to settle the final balance. At this point, only one transaction will be recorded on the blockchain, reflecting the final results of all off-chain transactions within the channel.

Routing Payments: If there is no direct channel, payments can be relayed through intermediate nodes. Nodes on the network automatically find the optimal path for payments.

Assuming Alice wants to pay 1 BTC to Bob:

Channel Creation: Alice and Bob create a payment channel on the blockchain, each depositing 1 BTC.

Off-Chain Transaction: Alice pays 1 BTC to Bob within the channel, resulting in updated balances of Alice 0 BTC and Bob 2 BTC.

Channel Settlement: Alice and Bob decide to close the channel and broadcast the latest balance state to the blockchain.

Technical Features

The core concepts of the Lightning Network mainly include two: RSMC (Recoverable Sequence Maturity Contract) and HTLC (Hashed Timelock Contract). The former addresses the confirmation issue of off-chain transactions, while the latter addresses payment channel issues.

RSMC (Recoverable Sequence Maturity Contract)

RSMC, or "Recoverable Sequence Maturity Contract," is similar to a funding pool mechanism, which ensures that a large number of intermediate transactions can be completed off-chain, only involving the blockchain during the final withdrawal. The main principles are as follows:

Creating a Payment Channel: The trading parties (for example, Alice and Bob) create a "micropayment channel" on-chain, pre-depositing a certain amount of funds. Initially, the funds are allocated according to the deposited amounts.

Off-Chain Transaction Confirmation: After each off-chain transaction, both parties jointly confirm the transaction results and sign, while invalidating the old version of the allocation scheme. If either party needs to withdraw, they can submit the latest signed transaction result to the blockchain for confirmation.

Anti-Cheating Mechanism: Any version of the allocation scheme requires signatures from both parties to take effect. If one party submits an old transaction result during withdrawal, the other party can provide proof of the latest version within a certain time frame, proving that the old scheme has been invalidated, and the funds from the old scheme will be forfeited to the disputing party.

Encouraging Off-Chain Transactions: Even if both parties agree to withdraw, the funds of the first party to propose withdrawal will arrive later than the other party, encouraging more off-chain transactions.

HTLC (Hashed Timelock Contract)

Micropayment channels are implemented through Hashed Timelock Contracts, which essentially means that both parties agree that the transferor first locks a sum of money and provides a hash value. If someone else can provide a string that matches this hash value within a certain time frame, the money is released. The HTLC mechanism can also be extended to scenarios with multiple intermediaries, creating virtual payment channels between any two parties. For example, if Party A wants to transfer money to Party C, Party C provides a hash value to Party A. Party A signs a contract with Party B, stating that if Party B can provide a matching hash value within a specified time, Party A will pay Party B the funds. Party B then signs a contract with Party C, and Party C provides a hash value to Party B, allowing Party B to receive funds from Party A. Ultimately, this enables Party A to transfer money to Party C through Party B.

Current Status of the Lightning Network

The technology of the Lightning Network is gradually maturing, and payment and social giants are also promoting the adoption of the Lightning Network. As of May 18, 2024, the Lightning Network has a total of 13,000 nodes, over 50,000 payment channels, and approximately 4,856 Bitcoins locked in channels.

Data source: https://1ml.com/statistics

The primary way to measure the growth of the Lightning Network is "public node capacity," which essentially reflects how much BTC is locked in public channels. We can see that public channels are gradually increasing in USD settlement. As adoption rises, the surrounding ecosystem infrastructure of the Lightning Network is also continuously developing.

Bitcoin Lightning Network Capacity, data source: https://bitcoinvisuals.com/ln-capacity

Ecosystem Projects

Like any emerging technology, the Lightning Network has continuously developed as a major transaction medium expansion solution for Bitcoin. With more projects entering the ecosystem and building solutions on it, the entire ecosystem is still in its infancy.

Source: Arcane Research

UXUY

The next-generation multi-chain trading platform UXUY, incubated by Binance Labs, officially announced support for the Lightning Network and Lightning addresses on December 5, 2023, becoming the world's first DEX to support the Lightning Network. This also marks the first milestone achieved by UXUY's Bitcoin Layer 2 initiative, Struck by Lightning. Before connecting to Bitcoin and the Lightning Network, UXUY had already connected to over ten public chains and Layer 2 solutions, including Ethereum, BNB Chain, Polygon, Tron, Optimism, and Arbitrum, and is leveraging the convenience of the Lightning Network to reconnect the entire crypto market.

In March 2024, UXUY Marketplace was launched, which is a stablecoin-friendly decentralized marketplace, offering advantages such as being stablecoin-friendly, decentralized, and low gas fees. Anyone can use the Lightning Network's Sats and stablecoins to trade Bitcoin assets like tokens and inscriptions.

Strike

Strike is a payment platform based on the Bitcoin Lightning Network, providing instant Bitcoin payment services. Users can use Strike to conduct various transactions with Bitcoin, such as online shopping, making small payments, tipping content creators, and buying and selling Bitcoin. This platform is the predecessor of the Bitcoin ecosystem wallet Zap. In September 2022, Strike completed an $80 million Series B funding round led by Ten31. Additionally, Strike has partnered with companies like Shopify and NCR to establish a system that allows merchants to quickly convert cryptocurrency payments into fiat currencies like USD.

Since El Salvador recognized Bitcoin as legal tender alongside the USD, Strike has become one of the most popular applications on the Lightning Network. Although this is currently the main application scenario, from the perspective of the Bitcoin network and ecosystem, Strike's limitation lies in its inability to bring more assets (such as USDT issued on the Omni network based on Bitcoin) into the Lightning Network, thus failing to provide more potential development opportunities for the Bitcoin ecosystem.

Taro
Taro is a new protocol based on Bitcoin's Taproot technology, used to define standards for issuing and using tokens on the Bitcoin blockchain. It is primarily applied to issuing assets on the Bitcoin blockchain, such as fungible tokens and NFTs. The protocol is developed by Lightning Labs, a company focused on Bitcoin Lightning Network technology, providing software support such as Lightning Network node management tools and wallets. Lightning Labs also developed the test version software LND, allowing users to send Bitcoin and Litecoin directly without requiring blockchain confirmations.

Taro relies on Bitcoin's latest Taproot upgrade, embedding arbitrary asset metadata by constructing a new tree structure, thereby leveraging the security and stability of the Bitcoin network, as well as the speed, scalability, and low fees of the Lightning Network. This allows Taro to be used in conjunction with multi-hop transactions on the Lightning Network, providing instant, high-capacity, low-fee transaction solutions. In April 2022, Lightning Labs secured $70 million in funding.

Lightspark

Lightspark is a provider of Lightning Network payment solutions, founded by former PayPal president David Marcus, primarily offering solutions for enterprise users to utilize Lightning payments, such as providing related APIs and SDK toolkits to support enterprise integration of the Lightning Network. In May 2022, Lightspark completed a funding round led by a16z and Paradigm. On April 30, 2024, the cryptocurrency exchange Coinbase partnered with Lightning Network infrastructure company Lightspark to launch support for the Lightning Network, providing its users with a faster and cheaper way to send, receive, or pay Bitcoin directly from their accounts.

Conclusion
It is believed that in the future bull market, especially with the arrival of the Bitcoin ecosystem bull market, as fees on the Bitcoin mainnet rise, we may see a surge in Lightning Network activity, with users beginning to adopt this cheaper transaction method. At the same time, with the continuous optimization of asset issuance methods like inscriptions and BRC-20 on Bitcoin, as well as the release of Taproot assets on the Lightning Network, all contribute positively to the future of the Bitcoin Lightning Network.