In short, the lightning network is an off-chain ledger for Bitcoin to keep transaction fees low and faster than on the actual bitcoin blockchain. It is considered a layer 2 solution to help scale bitcoin.
Before we dive into this, you need to know some basics about bitcoin.
First, bitcoin is coded to only perform around 7 transactions per second. This means only the transactions from the senders who pay the highest fees will get validated, and since bitcoin is quite popular, the fee to be included in the blockchain block has been up to $50 in the past. Imagine paying for your coffee and they tell you there is a $50 fee. Oh yeah, and to stay true to the analogy of bitcoin, imagine it would take 10 minutes before your purchase was confirmed, because that’s how long a bitcoin block takes to be validated.
Visa on the other hand, which has been used for a few years now at major retailers, can process up to over 50,000 transactions per second, and their fees are very low. They are also immediate. This is the reason you can pull out your card and swipe it at the grocery store or coffee shop – it’s quick, easy, and cheap to use.
That is the major problem that the lightning network solves, though.
Let me go through an example really quickly so you can understand roughly how the lightning network works.
Here’s a simple example, let’s say you go to the bar and buy a drink. You pay for it, including the bitcoin transaction fee. Maybe the fee was around $20 that night. As the night comes to an end, you’ve bought 6 drinks, and paid the transaction fee 6 times, which was more than the drinks, but you’re 6 drinks in so it doesn’t matter much to you.
One week later, you come back to the bar ready to tackle the beast, because this time you’re aware of what that bar did to your bitcoin wallet. You tell the barkeep “keep track of how many I order, and charge them for me all at once at the end of the night. Oh yeah, add something a little extra for yourself too”. This is the idea of a bar tab, and this is exactly how the lightning network works. Now you only have to pay 1 single transaction fee, instead of a bunch.
That example only included 2 participants, you and the barkeep. Here’s another example with a few other participants, because that’s the benefit of using the lightning network. Let’s say I come into a coffee shop and buy a $10 coffee because some big name brands like to apparently use gold in their espresso and I pay with bitcoin. Because of this, the fee is $20. So I pay $30 for my $10 coffee.
A few days later, the coffee shop decides to pay its workers using bitcoin. It pays them $500 each, but it also pays the $20 fee. Then one of the workers goes to their local grocery store with their new bitcoin and pays for some fruits. Probably some apples, potatoes, or pineapples, if they watched our other videos. They spend $20 of their bitcoin, and pay a $20 fee. Lucky for me, I actually work at that grocery store, so I tell the grocery store I want to be paid in bitcoin and they decide to try it out. They pay the $20 fee, even though they just subtract it from my pay.
Now, so far we have had a $10 transaction, a $500 transaction, and a $20 transaction, and another $500 transaction and have paid $20 fees each time, which is $80 total.
Where did that money come from and where did it go? It came from me and eventually made its way back to me. Well, at least $10 did.
What if there was a way I could have just kept my money and avoided those high fees?
This is the idea of the lightning network. It goes “Hey bitcoin transactions are expensive and slow, how about you give us your bitcoins and we will keep a record of how much you have based on your transactions on our cheaper and faster network… then when you want real money just let us know so we can mark our records and send you real bitcoin.This way you only pay us once and we pay you once.”
You and someone else deposit some money into a multisignature wallet and create what is called a payment channel. In this payment channel, you and someone else can send money back and forth, back and forth until you both decide to settle up and square up the payment channel with the main bitcoin blockchain.
Basically, you are creating a bunch of IOUs off the blockchain. Then when both parties agree to finalize all transactions, you put one single transaction on the blockchain network.
Now you might be wondering “Wouldn’t it be expensive and tiring if I had to open up a payment channel every time I wanted to pay someone or get paid?” That is a good question, however think back to our coffee shop example. What if all of that was off chain, and I basically just kept my original $10 IOU, instead of the money gathering fees from me to the coffee shop to the worker to the grocery store then back to me? It’s where the money ended up in the first place?
Well, it’s called the lightning network and it works very similarly to the way a lightning bolt looks like – using a system of payment channels, we can move money around in between people who already have payment channels.
For example, let’s say I wanted to send you a payment for clicking the like button on this video. However we don’t have a payment channel open. We both have a payment channel open with Coinbase though. So I tell the network I want to pay you $20, and it will send it to Coinbase, then from Coinbase to you, so basically I paid you, even though we used Coinbase as an intermediary. Imagine a network with 100,000 people, to where it’s all interconnected and once you join the network, you can send your IOU version of bitcoin almost instantly, almost free, and very easily.
So to conclude, the Lightning Network is a system set up to send bitcoin payments without the high fees and waiting on the 10 minute block time. Theoretically, the lightning network could scale up to a couple million transactions per second.
We don’t want to go into specifics, because that’s for another video, but we hope you enjoyed this video, and most of all we hope you learned something. Thanks so much for watching our videos and rewarding our hard work of creating honest, high-quality animated videos for cryptocurrency topics. We hope you see you in the next one!