Bitcoin's Second-Layer Solution: The Lightning Network
Because the Bitcoin blockchain can handle so few transactions per second, the more people use and transact on the Bitcoin network, the more expensive it becomes for a user to get their transaction included in a block. This has led many to begin devising ways to scale the capacity of Bitcoin. Since the security of the overall system is of the utmost importance and adding changes could lead to mistakes or vulnerabilities, one newly created scaling solution involves creating a second layer where transactions are recorded in a separate payment channel and not directly “on-chain.” To address just this, Joseph Poon and Thaddeus Dryja wrote the Lightning Network white paper, 'The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments' in 2015.
Bitcoin’s second layer is called the Lightning Network (LN). The Lightning network enables users to open multi-signature payment channels with each other in which they can send fractions of bitcoins back and forth without paying on-chain transaction fees each time. A Lightning channel is a bidirectional payment channel, meaning both parties can send and receive payments across the channel. If at any point one party would like to exit the channel or settle their transactions, they can close the channel and settle back on the base layer. This means users can fit many transactions into one fee-driven large settlement.
Importantly, as a second layer to Bitcoin, the LN is not its own blockchain or token. It is 100% reliant on Bitcoin for its security. the Bitcoin main chain acts as the final arbiter to any disputes on a second layer.
The most frequently cited analogy (and overly simplistic) is the “bar tab” analogy. In this example, when one goes to a bar with a credit card, they open a tab with the bartender if they intend on having multiple drinks. This person and the bar open a payment channel with the credit card. The patron then buys drink after drink all night (responsibly of course) and once finished, closes the payment channel and settles up. The only transaction that the bank sees is for the total amount of the drinks, not each individual drink.
Importantly, an individual doesn't need to have a channel open with the exact person they're trying to transact with. They only need to have a path from node to node to node that eventually links to that person. Routing is what enables transactions between two unconnected nodes to occur through pre-existing linked channels. Routing between other-wise unconnected nodes is enabled by Hashed Time Locked Contracts (HTLCs). An HTLC is a unique type of smart contract transaction and is used to allow one party to guarantee payment to another through a shared node connection. Separate individual nodes have the ability to allocate their bitcoin liquidity to help route payments between two parties that are not directly connected.
Lightning Network Routing Depiction. Source: CoinShares
However, one issue that exists is the lack of economic incentives for such a router. Solutions are being worked, like Lightning Pool, which provides a market where LN users can lease liquidity for payment channels. This creates a financial reward/incentive for other Lightning nodes to provide routing and increase liquidity.
Other improvements to the LN over the years include the Wumbo upgrade, which removed the original 0.1677 BTC limit to LN channels and allowed users to deposit more BTC. The original cap was imposed to limit user’s exposure to loss, should the LN encounter a critical big in its early stages. Wumbo channels allow large routing nodes to support much higher daily volumes, making the network more practical for all use cases, not just very small transactions.
To open a Bitcoin Lightning channel, two Bitcoin users will open a Lightning channel by depositing bitcoin in a 2-of-2 multisig address on the main chain and waiting for that transaction to be confirmed on-chain. Users can only send and receive up to the amount of bitcoin that was originally committed by both parties, no more. When the users are done transacting, the channel is closed with a final on-chain Bitcoin transaction. This final transaction reflects the net change in both user's balances from their time transacting off-chain.
As of Q3 2021, bitcoiners looking to use the LN now have more user-friendly options. User that wish to run their own Lightning node can choose from companies like Casa, Lightning Labs, or Umbrel and users looking for LN wallets can take a look at Phoenix, Muun, Breez, or Strike. Strike, possibly the most well-known Lightning service, is an app that enables users to transact on the Lightning Network with a USD bank account.
The first implementation of the Lightning Network was launched in March 2018 and was not possible until the implementation of another enhancement, SegWit. There are now several LN node implementations including Lightning Labs’ Lightning Network Daemon,Blockstream’s c-lightning, and ACINQ’s Eclair. All implementations compatible with one another meaning no matter which lightning wallet a user downloads, they will be able to communicate with the rest of the network. This is because all implementations follow the standards set by the Basis of Lightning Technology (BOLT).
Using the LN becomes easier as the network grows and since the start of 2021, the number of LN nodes has increased from 12,000 to 20,000+. The Lightning Network saw modest growth for years until recently. The LN began 2021 with ~1,000 BTC of capacity and has since increased to 1,800 BTC in seven months. LN Strike, a private company built on the Lightning Network, began working intimately with the country of El Salvador earlier this year as El Salvador prepared to make BTC legal tender.
Bitcoin Lightning Network Growth 2021. Source: Delphi Digital
Another scaling improvement to Bitcoin came with the activation of a backward-compatible upgrade (soft fork) including a patch called SegWit (Segregated Witness) in August 2017. SegWit, aside from patching a flaw in the protocol called transaction malleability, enabled each block in the blockchain to squeeze in more data, thus improving the number of transactions that can be processed with the same amount of blocks. Segwit adoption began slowly but has steadily risen over time. Average SegWit transactions rose from 36% in January 2019 to 54% in December 2019.