Have you heard of the Bitcoin Lightning Network? Many people believe that Bitcoin is the future of our financial system. But there is a big issue standing in the way of it’s scaleability.
Let me give an example. The payment provider Visa processes on average 4000 transactions / second. Visa can scale this to a maximum of 65,000 TPS.
Bitcoin on the other hand can handle approximately 7 transactions / second with a current block size of 1 MB. So lets take a closer look at the Bitcoin Lightning Network and see if there is a way to fix and scale Bitcoin.
Bitcoin Lightning Network
As mentioned Bitcoin is capable of up to 7 transactions per second on the blockchain. Clearly the main blockchain isn’t very scalable. But it doesn’t have to be. The community has come up with a new technique called the Lightning Network to solve the scalability issues.
They key idea is that small and everyday transactions DON’T have to be stored on the main blockchain. This avoids the 7 transactions per second limit. It is also called the off-chain approach.
Bitcoin Lightning Network – Example 1
So how does it work? Well lets take a look at an example shall we?
Lets say that every morning ‘Bob’ buys a cup of coffee on his way to work. Creating a transaction on the blockchain for a simple coffee is really overkill. He might actually pay more fees then the actual price of his coffee.
However with the lightning network Bob can set up a payment channel with the coffee shop.
To do that both the coffee shop and Bob deposit a certain amount of Bitcoin in what is called a multi-signature address.
Lets suppose Bob deposits 0.05 BTC and that the coffee shop deposits nothing because they don’t offer refunds.
This Multi-signature address is like a safe that can only be opened when both parties agree. When we open the payment channel we also make a balance sheet that says how the funds in the address should be distributed.
So right now it says Bob will get 0.05 BTC and that the coffee shop will get 0.00 BTC. The same as they deposited.
Opening the payment channel opens up the main blockchain so that there is full transparency.
The coffee shop owner can see that Bob has deposited 0.05 BTC and he can be rest assured he will get his money once the channel closes.
Now that the channel is opened Bob can order his morning coffee.
Lets say that a coffee cost 0.001 Bitcoin. To pay for it Bob simply changes the balance sheet. He subtracts the cost of the coffee from his balance and adds it to the coffee shops balance.
Bitcoin Lightning Network – Reduce the Load
So now it says that Bob will get 0.045 BTC and the coffee shop gets 0.005 BTC.
Bob and the coffee shop sign the updated balance sheet with their private keys. They then each keep a copy of it but they don’t do anything else with it.
Bob can keep ordering coffee as long as he has balance in the payment channel.
Both of them can make hundreds of thousands of transactions between them. There’s really no limit because this happens away from the main blockchain.
But all good stories come to an end. The payment channel can be closed at any time by either Bob or the coffee shop. All they have to do is take the latest balance sheet which was signed by both parties and broadcast it to the bitcoin network.
Miners will then validate the signatures on the balance sheet and if everything checks out release the funds according to the balance sheet.
This will create a SINGLE transaction on the bitcoin blockchain.
So the Bitcoin Lightning Network can significantly reduce the load on the main blockchain.
Bitcoin Lightning Network – Two Transactions
As you can see it only requires two transactions on the main blockchain.
One to open the payment channel and another one to close it.
It’s also very safe. The system assures that only the latest signed balance sheet can be used to unlock the money. And because both parties have a signed copy of the balance sheet they can release the funds at any time even if the other party doesn’t want to cooperate any longer.
So for example Bob cannot hold the money hostage that belongs to the coffee shop and vice versa.
But it doesn’t end there. You don’t need to open a direct payment channel with everyone you want to send Bitcoins to.
You can simply use the network to pass your coins around.
Bitcoin Lightning Network – Example 2
Here is Alice she is a friend of Bob. They’ve exchanged money on the Lightning Network before so they have an active payment channel.
Now lets say that Alice wants to buy a coffee. Instead of setting up a direct payment channel to the coffee shop she can transfer the money to Bob who can then transfer to the coffee shop.
So there is no need to create a payment channel with everyone.
In the Bitcoin Lightning Network your payment tries to find a route from person A to person B. It tries to do this with the least amount of intermediates and the least amount of fees.
This further reduces the strain on the blockchain but it requires the intermediates to have enough money in their payment channels.
With time this could have a tremendous impact on the price of Bitcoin in the future. So now you have a simple explanation of what the Bitcoin Lightning Network is and how it works.
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