Finance

The Lightning Network of Bitcoin; What Is It & How Does It Work?

Bitcoin is the first-ever cryptocurrency and still leads the crypto world in terms of; ranking and market capitalization. You can very conveniently trade Bitcoin via Bitcoin Prime. One of the major drawbacks of Bitcoin is its tortoise-like processing speed by which it can process only five transactions in a second. To cope with this problem, developers came up with the idea of the Lightning Network. It is a layer-2 solution that is buildable on top of Bitcoin’s layer-1. This layer contains different channels of payment created between the users of Bitcoin and other parties.

What Is Lightning Network?

Lightning Network is the addition of the 2nd layer to the blockchain of Bitcoin, which supports off-chain transactions, like transactions between those parties that do not exist on the blockchain network. The 2nd layer is formed by using multiple payment channels between BTC holders and other parties. One can define the Lightning Network as the two-party transaction mechanism utilized by parties to transfer and get payments from one another. Layer-2 increases the scalability of the Bitcoin network by handling the transactions externally at Layer-1 while still taking advantage of the powerful decentralized security model of the mainnet.

Why Do We Need the Lightning Network?

The Bitcoin blockchain utilizes a POW consensus algorithm to validate the transactions. This mechanism requires massive energy to run the computer network of validators for validating or processing the transaction. Nodes solve complicated mathematical puzzles and decode and thoroughly examine the data, but with immense power consumption. As the miners utilize their resources, the blockchain rewards them with freshly minted coins.

The addition of nodes raises the decentralization because it enhances the horizontal spread of transaction validators. If we continue to add more nodes to the mainnet (Layer-1), the newly added nodes will demand more & more energy, and resultantly the energy consumption will touch the sky. This slow-moving blockchain would also have to deal with massive amounts of data that will make the blockchain more sluggish. This is why; Layer-1 scaling is dismissed. At this point, Layer-2 comes to the ground and initiates to deal with the transactions.

It speedily validates the transactions and charges a lower cost. The question arises here that, if the addition of the second layer makes the transactional cost minimal, why would authenticators choose it? The answer is clear if the transactors are willing to make & receive payments immediately, they would have to pay a more or additional fee and somehow benefit the nodes so that they might choose their transactions on a priority basis. Blockchains are developed in such a way that they prioritize transactions according to the amount of fee to reward miners equally.

How Does It Work?

Bitcoin blockchain was developed to be a P2P transaction system. It never contained Smart Contracts, which was the project of Ethereum on its Proof-Of-Stake blockchain network. The Lightning Network provides this feature of Smart Contracts on Layer 2 of Bitcoin. These contracts are designed to create a Layer-2 payment channel between two parties. Each Smart Contract holds transactional data such as details of financial obligations and fulfillment of criteria, upon accomplishment of which, the Smart Contract automatically transmits the details to the blockchain to maintain the record of transactions.

Staking some of the BTC is mandatory to establish a payment channel. After the formation of a channel, both parties can make transactions quickly and economically. The receiver can invoice the transmitter as long as the BTC is staked and get the amount of the invoice. Once all the transactions are completed, it is possible to close the channel. And if the channel is required to be left open, the transmitter has to keep putting more BTC.

Pros & Cons

Pros

  • As the Lightning Network allows instantaneous and affordable transactions, it points out that micropayments do not cost much.
  • It minimizes the waiting times because payment channels assist in completing transactions.
  • Bitcoin’s Lightning Network inherits the powerful security model of its underlying blockchain.

Cons

  • This network requires a compatible wallet that accepts BTC only.
  • If a transactor needs funds, he must shut all the open channels to separate the Bitcoins pegged with them.
  • The closure of the payment channel by one party in the absence of the other party can result in the withdrawal of the funds of both parties, making it a scam.

Read More: How to Pay with Cryptocurrency

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