What is Lightning Network and how does it work?

Considered one of the most effective solutions for scaling cryptocurrencies, the Lightning Network is a smart contract system. Its main purpose is to enable fast and cheap payments between two parties on the Bitcoin blockchain.

Planned by Thaddeus Dryja and Joseph Poon in a 2015 white paper, the Lightning Network consists of user-created channels that securely and reliably send payments to each other.

For example, if you want to pay for a service using Bitcoin, you can simply open a Lightning channel and make payments from your wallet to the respective platform in a timely manner. Once the channel is closed, the net amount will be settled on the Bitcoin blockchain.

Since transactions are only between two parties and do not need to be broadcast to the entire network, they are instantaneous. And, due to the fact that there are no miners that need to be rewarded, transaction fees are almost non-existent.

Lightning Network how does it work?

Imagine that two parties who want to exchange currencies need to set up a multi-signature wallet (which needs more than one signature to confirm a transaction). The wallet address is then recorded on the Bitcoin blockchain. This starts the payment channel.

The two parties can now perform unlimited transactions without needing to access information that was originally stored on the blockchain. With each transaction, both parties sign an updated balance sheet to always show the number of Bitcoins stored in the wallet and exactly how much each is worth.

When the transaction procedures cease, the channel is closed and the resulting balance is recorded on the blockchain. In case of disagreement, both parties can use the most recent balance to recover their initial share of the portfolio sum.

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It's worth noting that transacting in Lightning doesn't require users to set up a direct channel in advance. You can send funds to third parties through channels with users with whom you are already connected. The network automatically searches and uses the shortest path.

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The benefits of the Lightning network

The main benefits of the Lightning Network have significantly reduced fees, instant confirmation times (no more ten minute wait to confirm Bitcoin transactions) and the possibility of improved privacy as these transactions are not kept on a public ledger for ever.

Small transactions or payments can easily move across the network with the help of Lightning, similar to the way data packets are sent over the internet. The platform has enough potential to produce new use cases that were not possible until now, such as machine-to-machine transactions, content micropayments, and instant asset exchanges.

There is also more room for improvement in the anonymity department, which could be provided by the Lightning Network, although there is still more to be developed in this particular segment.

In the long term, it seems obvious that the Lightning Network will slowly decrease the need for altcoins with lower transaction fees, but it remains to be seen if and when the effects of this protocol will be visible.