In this Article you will learn what is Lightning Network and how does it work shown on simple example.
What is Lightning Network?
That’s L2 for Bitcoin. It’s already been in use for quite some time, but it’s usability thus very cheap, fast and decentralized (there’s no explorer, it’s completely p2p).
How does Lightning Network work?
Bitcoin as a Layer 1 network is quite too expensive and way too slow to become an alternative to credit cards. Its Block time is around 15 minutes and network fee at around 2 dollars. Lightning Network is a Layer 2 to Bitcoin. It uses completely different system to make this a very quick and almost feeless. Both Networks are built on blockchains. On Lightning Network you connect to second wallet thru payment channels. Then you top up payment channels with fraction of Bitcoin. When making a transaction you send satoshis thru Lightning Network nodes to receipent. These payment channels needs to be both top up with at least little friction of bitcoin to pay routing fees.
Example
User 1 and User 2 would like to begin interacting with their Lightning network wallets. To do so, they will need to open a channel. It is only necessary for one party to open the channel, and the other does not need to grant permission for this.
Opening a channel
User 2 opens a channel with User 1 for a small fee In satoshis. Only the party opening the channel is responsible for paying this fee.
Funding a channel
When a channel is opened, it needs to be funded by both parties. Even if User 2 opened the channel to pay for a beer at the club and User 1 doesn’t intend to pay him at all, both need to have funds available. Both the sender and receiver need to pay a routing fee for every transaction. This fee is tiny, but the balance on the receiver’s side must be sufficient to cover it. In this case sender provides outbound Liquidity and receiver provides inbound Liquidity.
When User 2 pays for goods or services to User 1, the balance changes.
If User 2 spent all their funds, they can easily top up the channel using their Lightning wallet. To top up channel, he doesn’t need to cover any routing fees.
Afterward, User 2 can continue to purchase beer at the party using sats. However, it is important to note that the channel has a threshold, and funding the channel depends on the users. In this case, let’s say that User 2 opened a channel with a threshold of 0.02 BTC, which is 2,000,000 sats. User 2 then deposits 100,000 sats, allowing User 1 to receive funds up to the threshold limit.
When the threshold limit is reached, User 2 is no longer able to use the same channel to pay User 1. To continue interacting, they will have to open another channel. They can keep the previous channel open as long as they wish.
Closing a channel
The only way to withdraw funds to a wallet is by closing a channel. User 1 and User 2 can keep this channel open for as long as they want, but the only way to retrieve their liquidity is by closing it. Closing a channel updates the ledger on-chain on BTC network.
In the end it’s worth to say more about routing. Routing refers to the process of finding and forwarding a payment through a already opened payment channels between the sender and receiver. It is the way in which a payment can traverse through multiple channels and nodes to reach its destination. It’s important for the channels to have sufficient liquidity for this payment in these channels.
If User 1 wants to send a payment to User 3, but they have never opened a direct payment channel, the routing mechanism will use a channel between User 2 and User 3 (assuming one exists). The payment will then use the channel between User 1 and User 2 to reach User 3. The basic idea is that payments can be routed through a network of payment channels to reach their destination, even if there is no direct payment channel between the sender and receiver.
Summary
This is why a growing network of users makes transactions more efficient. Each payment channel along the route must have sufficient funds to cover the payment amount, as well as any routing fees associated with forwarding the payment to the next channel in the route. Routing will always guarantee the most optimal path for a transaction to reach its destination.
How does LN differ from standard payment system?
- You need to have liquidity (couple of satoshis) to receive the payment
- You need to open a channel which has threshold, it limitates transaction value
Advantages
- You custody your own money,
- It’s super duper cheap (around 2sats for payment = 0.00029 usd)
- It doesn’t need a terminal like cards do
- Almost full anonymity — only node contains these information, by running your own you are fully anonymous
Disadvantages
- It needs liquidity on both sides to receive a payment
- Opening a channel cost around 50–70 cents
I hope this explanation has clarified what Lightning Network is and made whole mechanism clearer.
In next article you will learn how to setup your first Lightning Network Wallet and how to fund it. It’s very easy and intuitive.
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