Lightning Network Definition: What It Is & Why It Matters

Written by Sean GraytokUpdated: 26th Sep 2021
Share this article

Disclaimer: This post contains references to products from one or more of our advertisers. We may receive compensation (at no cost to you) when you click on links to those products. Read our Disclaimer Policy for more information.

What is the Lightning Network?

The Lightning Network is a layer two solution that enables instant and low-cost Bitcoin transactions. It solves one of Bitcoin’s main critiques: scalability.

While Visa’s network handles around 65,000 transactions per second, the layer one Bitcoin network can only process around 7 transactions per second. This limits Bitcoin’s ability to scale and potentially serve as a medium of exchange sometime in the future.

Using layer one Bitcoin to buy a coffee might take an hour, and transaction fees could cost more than the coffee itself. It’s inefficient to use the main chain for small, everyday transactions.

The Lightning Network solves scalability issues by using smart contracts to facilitate small transactions “off-chain” from the main Bitcoin Blockchain.

That’s what “layer two” refers to — the Lightning Network is built on top of Bitcoin.

The Lightning Network enables payments to occur in milliseconds and can facilitate millions to billions of transactions per second across the network.

It allows users to benefit from the security and decentralization of Bitcoin while conducting instant and low-cost transactions. But how exactly does it work?

Understanding the Lightning Network

Two parties using the Lightning Network can open an off-chain payments channel on layer two.

Each party deposits a certain amount of BTC into the channel, and this information is broadcasted to the layer one public Bitcoin Blockchain.

Now, the two parties are free to make as many transactions as they wish, all occurring off-chain on layer two. To spend funds within the channel, both parties must agree on the new balance.

They’re essentially creating IOUs on a ledger where each party signs off on each exchange. The main chain does not see any of these transactions.

When they want to stop transacting, the most recently agreed-upon version of the ledger is broadcasted to the layer one Bitcoin Blockchain, and final settlement occurs.

The two parties may have conducted 1,000 transactions off-chain, but the Bitcoin network only processed two of them: the transaction that opened the payment channel and the one that closed it.

The 998 transactions in between were free and instant because they were not recorded on the public blockchain and did not require proof of work.

Lightning Network Special Considerations

Two transacting parties do not need to open a unique channel between them. The Lightning Network allows a party to jump through connected payment channels of other participants in the network.

From the Lightning Network whitepaper: “Requiring everyone to create channels with everyone else does not solve the scalability problem.”

The network of channels solves the scalability problem because it creates a near-finite amount of transactions inside the network.

Additionally, the Lightning Network theoretically improves with each new participant, making it globally scalable due to powerful network effects.

More efficient payment channels are created as new users join the network.

The Lightning Network’s Fraud Detection System

When two parties open a bidirectional payment channel, they’re actually placing funds into a two-party, multi-signature channel bitcoin address. The placement of funds acts like a security deposit.

The terms of the multi-signature contract are that both parties commit to broadcasting only the most recent transaction.

As previously mentioned, every time a transaction occurs, each party agrees on the updated balance by signing the ledger in accordance with the contract.

The current version of the ledger indicates each party’s allocation, and all older transactions are invalidated.

The Lightning Network does not require “cooperation from the counterparty to exit the channel.” Each party is free to close the channel and end the relationship at any time.

Once this occurs, the updated signed version of the ledger is broadcast to the public ledger, miners verify, and final settlement occurs.

If a party does not broadcast only the most recent transaction but instead broadcasts any older transactions, they have violated the contract terms.

As a penalty, the violating party’s ‘security deposit’ will be transferred to the other party in the channel.

Lightning Network FAQs

What does the Lightning Network do?

The Lightning Network enables faster and cheaper transactions in the Bitcoin ecosystem. It is a layer two technological solution that allows two parties to conduct transactions off-chain. This decongests the layer one public blockchain because only the initial opening of the payments channel and the final settlement are recorded on the main chain.

How does a lightning channel work?

Two parties open a lightning channel, and they each deposit BTC into it. The opening of this channel is recorded on Bitcoin’s public ledger, but all subsequent value exchanges occur on layer two. After every transaction, each party signs off on the updated balance and agrees on the ledger’s state. Once a party decides to close the channel, the current state of the ledger is broadcasted to layer one, and a final settlement occurs.

Does bitcoin use the Lightning Network?

Yes, Bitcoin uses the Lightning Network. It was first formally elaborated in a paper by Joseph Poon and Thaddeus Dryja in 2015. The Lightning Network is software and, therefore, in a perpetual state of improvement.

Bottom Line: Lightning Network Definition

Other cryptocurrencies aren’t trying to be “better money” than bitcoin. Most are application-based technological innovations optimizing for speed and functionality.

The Lightning Network makes everything possible in the Bitcoin ecosystem while using the best version of money ever created.

This article is for informational purposes only. It is not intended to be investment advice.

Sean Graytok
Sean Graytok

Sean Graytok is our Co-Founder and leading expert in investing and financial management. His work has been cited in leading industry publications, such as InvestorPlace and Business Insider. Sean is interested in the people and technologies that are improving the world.