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“You can think of the Bitcoin blockchain like a road, and a lot of cars want to get on the road. Right now, there’s a lot of traffic.” Elizabeth Stark, CEO and co-founder of Lightning Labs.

It was a little over nine years ago when Satoshi Nakamoto published the much-revered Bitcoin whitepaper, which laid out a vision of a “purely peer-to-peer version of electronic cash” that would “allow online payments to be sent directly from one party to another without going through a financial institution”. But these days, one can reasonably conclude that Bitcoin tech is starting to show its age. Transaction rates are slow (indeed, in recent times they have dipped to just three transactions per second), especially when compared with fellow cryptocurrency projects such as Litecoin, Ripple and Bitcoin Cash, as well as with well-known cross-border payment systems such as PayPal, which can process over 100 transactions a second; and Visa, which can be cranked up to nearly 4,000 transactions per second.

Bitcoin’s limitations are creating a massive backlog on its network, which in turn has pushed up transaction fees over $5, as users provide ever-increasing financial incentives to miners to prioritize their transactions, and which has significantly delayed transaction confirmation times. As other coins adopt newer technology and are demonstrating considerably more impressive throughput rates, the Bitcoin community is now pressing with more urgency for something to be done. In fact, several things have already been done. The well-publicised drama over the last few months pertaining to hard forks was largely in response to the community attempting to reach consensus on an appropriate scaling solution. But with miners, developers and users all at loggerheads with each other, we have seen endless, often-exasperating wars between various factions.

That being said, a scaling proposal has now emerged over which the community has been considerably more supportive – the Lightning Network. And that means that those who have been forewarning of Bitcoin’s imminent demise on the basis of its inferior credentials may just want to hold off writing their final obituaries.

How does the Lightning Network work?

As observed by Lightning’s creator Elizabeth Stark, “we’ve created this layer on top of Bitcoin that can relieve the congestion…and as a result you can transact faster…”. The main idea behind the Lightning Network is that small, everyday Bitcoin transactions don’t have to be stored on the Bitcoin blockchain. At its core, it provides a payment channel for those wishing to transact such small amounts. But rather than being a fork-related solution that alters the contents of each block or increases the block size, Lightning is a separate protocol on Bitcoin’s blockchain. It is a multi-layer solution whereby the second and third layer on top of the blockchain will permit users to execute small Bitcoin transactions almost instantly and with zero transaction fees.

Suppose Person A wants to send 0.5 BTC to Person B. In the current environment, Person A would do this by building a transaction from her wallet and then using her private key to authorize the transaction. After the transaction is signed by Person A, it is then broadcast to the rest of her peers on the Bitcoin network, before being mined and placed into an upcoming block on the chain, (or more accurately in today’s climate, placed into the long queue of transactions waiting to be written onto the chain). Normally, however, the process of Person A creating and signing the transaction can be done offline without the network knowing – it is only when the transaction is then broadcast that the network picks it up to be mined and ultimately written onto the blockchain.

The addition of the Lightning layer, however, allows for the parties to interact with each other off of the blockchain; instead, they can trade directly between them for the most part without the network being aware. Such a facility is known as a ‘payment channel’, whereby both parties create a shared account called a ‘multi-sig address’ in which each party puts in an agreed amount of Bitcoin, and which requires both of them to sign using their respective private keys. The process of placing BTC into the multi-sig address opens up the payment channel, and it is at this singular point in time that both parties interact with the blockchain network. The only other time the network is accessed is when the channel is closed and both parties are ready to redeem their BTC from the channel. Onlyon these two occasions will the miners be able to add transactions to the blockchain – between opening and closing the payment channel, however, persons A and B can transact with each other as many times as they like without involving the network. Once the channel is closed and the Bitcoin is apportioned appropriately between the two parties as dictated by the agreed transactions, the final status of those transactions is then picked up by miners and written onto the blockchain.

This ultimately means that transactions can be conducted without having to use the congested Bitcoin blockchain. And given that there are the only two points in time when the network is involved in the transaction (i.e. when the channel is opened and closed), the Lightning Network is considered as an ‘off-chain’ scaling solution for Bitcoin. As the authors of the Lightning Network’s whitepaper explain, “if only two participants care about an everyday recurring transaction, it’s not necessary for all other nodes in the bitcoin network to know about that transaction”.

But why just stop at two participants? Indeed, the Lightning concept can be extended to many more parties, which in turn creates a network of payment channels whilst allowing for only seldom interaction with the Bitcoin blockchain. And because the congested blockchain won’t be frequently accessed, transactions can thus take place at ‘lightning’ speed. So, in the case of three individuals A, B and C, such that a payment channel exists between A & B, and one is created between B & C, should person A want to send 1 BTC to person C, she would ask B to transfer 1 BTC via the B/C payment channel, and then she could repay B via the A/B payment channel.

The successful running of the Lightning Network also depends on Segregated Witness (or ‘SegWit’), which was adopted by the Bitcoin community in August 2017. This scaling implementation improves the capacity of each block of transactions. It also fixes a problem known as ‘transaction malleability’, whereby if one party signs a transaction, someone else could hypothetically generate another identical transaction but with a different valid signature. And changing the signature changes the entire transaction ID which means that the Lightning Network, which depends on IDs of transactions not yet committed to the blockchain, could be disrupted by potential sabotage. But SegWit solves this malleability problem, and thus makes implementation of the Lightning Network significantly more effective.

What does implementation of the lightning network mean for the future of Bitcoin and cryptocurrencies?

There is now much anticipation among cryptocurrency users worldwide that the Lightning Network will comprehensively transform the capabilities of Bitcoin going forward. It will hopefully allow the world’s most valuable cryptocurrency to run as the high-speed payment mechanism that was initially intended by its creators, and should also enable it to compete with the incumbent leaders in this market, such as Visa and PayPal, as well as the likes of Litecoin and Bitcoin Cash. Indeed, successful implementation of the Lightning Network will also go a long way towards ensuring that hard forks àla Bitcoin Cash need not be necessary in the future in order to address Bitcoin’s scaling issues. The potentially vast network of payment channels that Lightning could well facilitate would be able to take millions of transactions off chain, thus freeing up the painful backlog Bitcoin holders are currently experiencing.

Since the problematic issue of long block confirmation times doesn’t emerge on the Lightning Network, near-instant transactions can be achieved with payments being sent in a few seconds at the very slowest. And being an off-chain solution, moreover, the Lightning Network allows for exceptionally low fees. Indeed, the network’s creators Joseph Poon and Tadge Dryja believe that fees will be near-zero, with Poon recently stating that“The fees people are going to charge are going to be effectively near zero. If you really game it out for a lot of payments, one satoshi is too high; that’s really what we’re looking at.”

The emerging use case of micropayments will also be supported on the Lightning Network, which means that one should be able to send funds as low as 0. 00000001 Bitcoin without custodial risk. In contrast, the Bitcoin blockchain at present “currently enforces a minimum output size many hundreds of times higher, and a fixed per-transaction fee which makes micropayments impractical,” according to the project’s official summary.

But while Lightning does appear to be somewhat of a godsend for Bitcoin, given the mounting frustration people have been experiencing in recent times, there are limitations to this new solution to keep in mind. Principally, it is designed for the purpose of small transactions – which means that it is less than ideal for executing larger payments. In fact, payments using Lightning are limited to a maximum of 0.042 BTC; and whereas miners charge transaction fees on-chain according to transaction weight, Lightning charges fees in proportion to the amount being sent, using a flat fee + rising percentage system. As such, larger amounts will invariably be cheaper to send on-chain, rather than with Lightning. And while the Lightning Network may function as a second layer solution, it is still wholly dependent on Bitcoin – that is, should Bitcoin fail, then so too will Lightning.

Lightning is also being designed for Ethereum, which suggests that if it proves successful, the potential for millions (or even billions) of transactions per second could soon become a reality across a growing number of notable blockchain projects. That being said, Ethereum founder Vitalik Buterin has indicated his preferencefor on-chain scaling solutions; in particular, Ethereum is hoping to introduce a process called ‘sharding’ in order to achieve this goal. But while such a proposal remains nowhere near ready, the Lightning Network in contrast is already available to be tested by the public.

Indeed, early-December saw the Lightning Network developers manage to successfully send “the first-ever interoperable Lightning transactions using real bitcoin.”And right at the end of the year, the first transaction using bitcoin to execute a payment on the Lightning Network was completed, with the aid of mobile top-up service BitRefill. So things appear to be progressing quickly, although according to the official post from Lightning developers, while we are moving closer to an official launch, more work needs to be done, particularly with regards to ensuring both the security and stability of the network.

In recent weeks, Bitcoin’s dominance has fallen from above 50% to around 35% today in terms of its share of cryptocurrency market capitalisation, thanks to some spectacular gains being achieved by peers Ripple, Ethereum and Bitcoin Cash. Questions continue to abound over whether Bitcoin can continue to match the transactional throughput capabilities of such projects going forward; indeed, such concerns are perhaps weighing on Bitcoin’s price trajectory at the moment. But with such a hotly anticipated solution soon to be applied to the world’s leading cryptocurrency in the form of the Lightning Network, it would appear that Bitcoin may well remain “king of the cryptos” for some time to come.

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Dr Justin Chan co-founded OCIM and serves as Chief Investment Officer for its fund management platform. Within OCIM, He co-manages OC Horizon Fintech, where he translates real applications and future-awareness into investment performance. He also oversees a number of important tech projects in the fintech and data science space. Prior to co-founding OCIM, he worked as a senior quantitative strategist at GMO and developed in-house trading strategies. An expert in microstructure, market liquidity and behavioral finance, Dr Chan holds a doctoral degree from UCLA, and once served as assistant finance professor at Singapore Management University. He can be reached at justinchan@datadriveninvestor.com.

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