Why do we need the Bitcoin Lightning network?

introduction

The Bitcoin Lightning network is enjoying increasing popularity. The distribution and adoption of Lightning is progressing steadily – despite fluctuating Bitcoin prices: There are now more than 4,800 Bitcoin in the Lightning system, which currently corresponds to more than 90 million US dollars. In addition, increasing institutional activities can be observed around Lightning. For example, Lightning Labs, which is driving the development of the protocol, received $70 million in Series B funding earlier this year. The number of companies offering Lightning-related services is increasing rapidly.

This series of articles examines fundamental aspects of the Lightning network. The focus is on questions about the motivation, functionality, use cases, and the current and future importance of Lightning. The first part of the series addresses the question of why you need the Lightning network.

Bitcoin as a global monetary system?

Bitcoin offers numerous advantages as a decentralized monetary system that allows money to be sent around the world without intermediaries. These include, for example, low barriers to entry: anyone with an Internet-enabled device can use the Bitcoin protocol. No one can be excluded, which has a positive impact on financial inclusion. Bitcoin is also a scarce digital commodity, a kind of “digital gold”. Each bitcoin can be divided into 100 million satoshis, just like one euro can be divided into 100 cents. Unlike fiat currencies, the Bitcoin protocol limits the money supply to around 21 million bitcoins. Thus, a “devaluation through dilution” is impossible.

Despite the advantages mentioned, the current state of the technology also has disadvantages. For transactions via the Bitcoin blockchain, the decentralization of the network comes at the expense of the transaction throughput, i.e. the transactions that can be carried out per second. A maximum of seven transactions (“on chain”) can be confirmed per second via the Bitcoin network.

This transaction throughput is insufficient to function as a payment system. Established payment service providers such as Visa or Mastercard enable several thousand transactions per second and thus scale much better – albeit completely centralized. Payments usually need longer time windows until they are confirmed (“gemined”) and are therefore not suitable for everyday payment transactions. Another limitation is small payments via bitcoin. There is a fee for each transaction, which is based on the storage size. The more memory consumption, the more expensive the payment. On average, a transaction currently costs around 1 US dollar, regardless of its volume. At times of increasing demand, such as in 2017, transaction fees peaked at more than 60 US dollars. For large payments, the transaction fees may seem rather cheap; However, small payments are usually uneconomical due to the proportion of transaction costs.

Lightning scales Bitcoin for everyday use

The goal of Lightning is to make Bitcoin suitable for everyday use as a means of payment. The top priority is to increase transaction throughput without centralization, as we know it from payment networks like Visa or Mastercard. In more detail, this means more payments on more favorable terms. While Satoshi Nakamoto’s Bitcoin whitepaper was published back in 2008, the idea of ​​the Lightning network dates back to 2015. The first implementations started in 2016, the first use of the implementations followed in 2018. Since then, the technology and the network have developed rapidly. However, despite a serious size and state adoption, it is still in its infancy in 2022.

How does Lightning solve the problems of low transaction throughput and relatively high transaction fees? Not all payments are written to the blockchain (i.e. are “on-chain”), but payments are carried out among themselves (“off-chain”) and only written to the blockchain or the payment in extreme cases or when a financial relationship between two network participants ends settled there. Payments from users can be processed in real time and at low cost. Users sending money via Lightning don’t have to wait for mining; Payments are processed immediately

How does the Lightning network work?

The following practical example explains how Lightning works. Alice is visiting a bar with friends and wants to invite her friends over. However, it is too time-consuming for them to pay for each drink individually. Alice deposits her credit card at the bar. Each drink of the group is written down by the bartender. At the end of the evening, the bartender creates a bill for all the drinks, which Alice ultimately pays. This type of payment, known as “opening a tab”, is common practice in the US and UK.

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This example shows some similarities to how the Lightning network works: Individuals send IOUs to other individuals or merchants or restaurants via so-called payment channels (off-chain). In theory, an infinite number of IOUs can be exchanged between the two parties. In the end, the payment is finally settled in Bitcoin (on-chain). However, the example lags a bit, since the Lightning network can do a lot more: There is no need to trust the other party and you can also use the so-called routing to make payments to people with whom there is no direct payment channel. But more on that in the following articles!

Conclusion

The Lightning Network is the next evolution of Bitcoin. Although Bitcoin enables worldwide transactions without intermediaries, the processing of all payments via the Bitcoin blockchain also has limitations. Through Lightning, the transaction throughput can be increased significantly: a necessary condition to be used on a large scale as a payment system. With Lightning, small payments can be made at a fraction of the cost, which can lay the foundation for an entire micro-payment economy. How exactly the Lightning network works in detail, we will discuss in the second part of the article series.

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About the authors

dr Jonas Gross is Head of Digital Assets and Currencies at etonec GmbH. Jonas holds a PhD in Economics from the University of Bayreuth and his main areas of interest are digital central bank currencies, stablecoins, cryptocurrencies and monetary policy. In addition, Jonas chairs the Digital Euro Association (DEA), co-hosts the podcast “Bitcoin, Fiat, & Rock’n’Roll” and is a member of the Expert Panel of the European Blockchain Observatory and Forum. You can reach Jonas at [email protected].

Jonathan Knoll is the founder and managing director of etonec GmbH. He has over 25 years of experience in the #payment & #banking and #blockchain industry, working for innovative companies such as Sun Microsystems, PayPal/eBay and Libra/Diem, where he was Head of Strategic Partnerships. At etonec he looks forward to developing solutions at the interface of crypto, payments & banking and regulation. Jonathan can be reached at [email protected].

Yannic Fraebel is the managing director of App Learning GmbH. He did his master’s degree in business informatics at the University of Applied Sciences in Munich. His focus is in the areas of Bitcoin, cybersecurity and economics. Yannic is also an advisor at Blockchain Founders Group AG (BFG) and a former mentor of the DeFi Talents Program. You can reach Yannic at [email protected].

The authors would like to thank René Pickhardt and Denis Scheller for their great support and feedback. Your insights and comments were essential in making this article a reality.

The original article appeared on the etonec homepage.


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