What is the Bitcoin Lightning Network and how does it work?

One of the criticisms often levelled at Bitcoin is that it’s too slow and cumbersome to handle everyday micro transactions like buying cups of coffee, lottery tickets, or using a vending machine to buy a snack.

Bitcoin only confirms blocks of transactions every ten minutes on average, and each of those blocks can only contain a limited number of transactions, which throttles its throughput.

At first glance this looks like a fundamental flaw, but it is in fact by design. The ten-minute block time ensures Bitcoin’s mining reward schedule (and therefore inflation rate) remains predictable, and the limited blocksize keeps the network decentralised by making it lightweight enough for anyone to run a full node.

Nevertheless, the result is that on-chain payments aren’t particularly practical for small everyday transactions. Nobody wants to wait ten minutes at a vending machine, and as Bitcoin’s popularity increases, competition to be included in the next block may cause fees to become too high to be practical for small payments anyway.

To put things in perspective, consider that Bitcoin can handle a throughput of roughly 7 transactions per second (TPS), whereas Visa can process up to 65,000! Things can be extremely efficient when they are completely centralised.

Shitcoiners have used these arguments for years to try and claim that Bitcoin can’t scale, and that you should use their ‘faster’, ‘better’ shitcoins instead. What they don’t tell you is that Bitcoin IS scaling, through something called the Lightning Network, which allows you to send Bitcoin almost instantly and practically for free.

This week, let’s take a closer look at the Lightning Network, how it works, and why it’s a valuable tool you should learn how to use if you want to start making fast and cheap everyday payments in Bitcoin. And who wouldn’t want to do that?

‍

What Is the Lightning Network?

There are a couple of rudimentary ways to scale the TPS that Bitcoin can handle, but each of them comes with an unacceptable trade-off.

We could make Bitcoin blocks much larger, allowing more transactions per block, but this would only lead us towards centralisation. The blockchain would become bloated to a point where the hardware requirements of running a node become something only large organisations can manage. If we follow this path, then we could quickly find ourselves in a world of gatekeepers and potential censorship again.

We could instead take the easy route and follow the same path as gold. When gold was too cumbersome to trade day to day, we let banks hold it for us and traded in paper IOUs instead. We could do the same here and let large institutions hold our Bitcoin while we trade in frictionless digital IOUs.

But this is not a credible solution either. We should all know well enough by now that trusting a third party to hold your Bitcoin is a risk that’s simply not worth taking.

The Lightning Network is a solution developed by Lightning Labs that attempts to solve the problem of enabling small, frictionless payments using Bitcoin, but without resorting to making these two unacceptable trade-offs to achieve it. Working as a ‘layer 2’ solution, the Lightning Network is designed to facilitate instant small payments ‘on top’ of Bitcoin itself, but without clogging up the main chain or incurring an on-chain fee every time a transaction is made.

The result? You can make secure, self-sovereign Bitcoin payments for even very small transactions almost instantly at practically zero cost. Not to mention, the Lightning Network offers some real privacy benefits as well!

‍

How does the Lightning Network Work?

The Lightning Network facilitates instant, low-cost payments by enabling groups of Bitcoin transactions to take place off the main blockchain (off-chain) before then consolidating, verifying, and settling them later on-chain in a single transaction.

To do this, Lightning relies on its own network of nodes (distinct from Bitcoin nodes) that run software allowing them to communicate and open ‘off-chain’ payment channels with one another. Through these channels users can then transmit instant and fast payments to each other privately, without publicly broadcasting each transaction to the main chain.

Probably the easiest way to conceptualise what’s happening is to think of the Lightning Network as working a bit like a bar tab. Instead of paying for every drink in a separate transaction, you just keep a running total of the balance as you go and ‘settle up’ in a single transaction at the end.

Opening Bitcoin Lightning Payment Channels

Opening a Lightning payment channel with another node starts by making an on-chain transaction. Both parties start by depositing Bitcoin into a 2-of-2 multi-signature address to ‘fund’ the channel and create a pool of funds they can transact back and forth with.

Transacting Over the Bitcoin Lightning Network

Once this initial multi-sig transaction confirms, the Lightning channel is opened, and the two parties can transact freely with one another while the software keeps track of the balance of payments between them.

Closing Bitcoin Lightning Network Channels

Once the two parties have finished transacting, either one can then close the channel at any time by making a final on-chain transaction which reflects the net changes to both of their balances.

This will close the channel, and each user will end up with the correct balance of funds now recorded on Bitcoin’s main chain. The only Lightning-related transactions that are broadcast to the Bitcoin network are the opening and closing of channels.

Routing Payments Over Lightning

The explanation provided so far is a little simplified. It suggests that you would need to open an individual Lightning channel with everyone you wish to transact with. But this isn’t particularly practical. Not every node on the Lightning Network is connected, and you don’t want to have to open a ‘digital bar tab’ with everyone you want to make a payment to.

Thankfully, you don’t have to. The Lightning Network is much smarter than that. It makes use of something called ‘routing’ that allows payments to hop through a series of pre-existing channels.

While you may not have a direct channel open with the person you’re trying to pay, your payment can find a ‘route’ through multiple connected channels to reach the correct destination, provided there is enough liquidity (enough deposited funds) in each of the channels along the route between you and the recipient.

‍

Using the Bitcoin Lightning Network

The Lightning Network is an extremely useful tool for any Bitcoiner. It can make your Bitcoin payments faster, cheaper, more private, and more practical for day-to-day transactions.

The key is learning how to use it properly, and just like with on-chain Bitcoin, it pays to do a little bit of homework to make sure you are using Lightning in the most secure and sovereign way possible.

Choosing a Bitcoin Lightning Wallet

There are two main types of Lightning wallets: custodial and non-custodial.

• Custodial wallets, as the name suggests, are wallets where you are not in full control of your own funds. Any Bitcoin deposited into a custodial Lightning wallet is controlled by your wallet provider, who manages your private keys for you. This puts your funds at risk if that provider is dishonest, gets hacked, or goes out of business.

• Non-custodial wallets put you in full control of your funds. You are responsible for looking after your private keys, and your wallet provider has no access to or control over your Bitcoin. This is far more secure but does require you to employ some discipline and take on more responsibility.

We would always recommend taking the time to learn how to use non-custodial wallets. Just like with on-chain Bitcoin, we think counterparty risk is an unacceptable trade-off. One of the best things about Bitcoin is that it doesn’t need any trusted third parties to work. Using the Lightning Network is no reason to revert to the old way of doing things via ‘trusted’ intermediaries.

Run Your Own Bitcoin Lightning Node

It couldn’t be easier to start transacting on the Lightning Network. There are plenty of wallets you can download, fund, and start using straight away.

But if your goal is to be fully self-sovereign, then when transacting over the Lightning Network, by far the best approach is to set up and route payments via your own Lightning node.

Doing so will give you access to some great benefits:

Enhanced Privacy

The Lightning Network is a great way to enhance the privacy of your spending habits because channels are private, and transactions are not broadcast publicly. The only transactions visible to the network are the on-chain transactions used to open and close channels.

What happens within a Lightning channel stays within the Lightning channel.

Running your own Lightning node takes things one step further and gives you even more control.

You could choose to run a public Lightning node and reveal your node’s balance and state to try and help route other people’s payments, but you can also choose to run a private Lightning node that keeps your channel balances hidden and your spending completely private.

Full Sovereignty

The only way to maintain full sovereignty when using the Lightning Network is to run your own Lightning node. It allows you to open and close your own channels and move your Bitcoin to the main chain yourself, and it also means that no third party can easily snoop on or try to censor any of your payments.

Running your own Lightning node means that you aren’t reliant on any third party to hold your funds, open and close channels for you, or accept and process your payments. Just like with on-chain Bitcoin, running your own node allows you to be fully self-sovereign.

It’s an empowering feeling knowing you can have access to instant Bitcoin payments anywhere in the world without having to rely on any third party.

Growing Liquidity

Running your own Lightning node could lead to significant benefits in the future. By spending via your own node, you will slowly be building something known as ‘inbound liquidity’ with each payment you make. As this inbound liquidity grows, your node will become more useful to the network as it becomes more capable of accepting or routing more payments.

In a world living on a Bitcoin standard where everyone wants to transact in Bitcoin, this could turn out to be a very worthwhile investment, not just strategically but monetarily too!

Not only are you building useful infrastructure that could be used to operate your own Bitcoin business, but you can actually earn sats by routing other people’s payments and supporting the network as well.

Earning Sats!

That’s right. Your Lightning node can earn you Bitcoin by helping to route other people’s payments around the network as they try to reach their intended recipient!

But don’t get too excited just yet. Lightning payments are incredibly cheap, and the fees are so small they are almost negligible. You would have to route an awful lot of payments to make any significant income, and there is some significant complexity involved if you want to try and do it profitably.

Nonetheless, you will be rewarded for helping the network, and if your node does manage to accrue enough liquidity, others will be keen to connect to you and will even pay you a fee to open a channel with them to help route their payments more effectively.

If you start building your liquidity and running your own lightning node today, there’s no telling how valuable or useful that might be ten years from now. It’s always the pioneers who find the best treasure…

Ride the Lightning – The Bitcoin Way

All over the world people are using the lightning network to build communities and make peer-to-peer payments without having to rely on any traditional banking infrastructure whatsoever.

It’s a beautiful thing.

If you’re on your own path to becoming financially self-sovereign, then after mastering on-chain Bitcoin, mastering the Lightning Network is the next obvious progression. Being in the position to make instant peer-to-peer payments anywhere in the world is what real empowerment feels like and puts you in the best position possible to navigate the future of money.

When you’re ready to learn how to ‘ride the lightning’ and send near instant peer-to-peer transactions via your own lightning node, then our experts are here to help. Just book a free 30-minute consultation and we’ll start your training right away.