A decentralised system to process high volumes of instantaneous micropayments and provides a solution to the scalability problem as it can support millions of transactions per second.

A criticism related to Bitcoin is its inability to execute a high volume of transactions in a short time frame. Given that a block is added to the Bitcoin network every ten minutes and that the block size is limited, Bitcoin is only able to execute 5–7 transactions per second, whereas VISA executes more than 20,000 in the same time frame. The Lightning Network however is a solution to this problem. 

The Lightning Network protocol was introduced by Joseph Poon and Thaddeus Dryja in a paper published in January 2016,  and pointed to this protocol as the solution to Bitcoin's scalability problem. The Lightning Network is a Layer 2 communication and payment protocol built on Bitcoin blockchain. In other words, the Lightning Network is a decentralised network for high volumes of instantaneous micropayments, which would allow the user to make immediate transactions with very low fees. The solution allows transactions to be processed off-chain, taking the load off the main network and improving network scalability.

For example, Bitcoin adds transactions to blocks spaced approximately every ten minutes. Moreover, as blockchain networks gain popularity, the number of transactions is growing exponentially, which means an increase in demand for space in each block, thus driving up transaction costs. This issue of time and cost means that Bitcoin blockchain is essentially unviable for micropayments. Imagine waiting ten minutes at a coffee shop counter to confirm your coffee purchase.

The Lightning Network resolves these issues. Payments on this network do not require block confirmations and are therefore instantaneous. It also allows payments for small amounts, with much lower fees compared to those using blockchain validation. Another major advantage of this network is its scalability – as it can support millions of transactions per second. Ultimately, this network eliminates the risk of delegating custody to third parties.

The Lightning Network works somewhat differently to the blockchain network and operates through payment channels. Parties open a payment channel between each other by sending funds in an initial transaction to a multi-signature address, which is managed by both involved parties and requires the signatures of both these parties to create new transactions. This initial transaction is then propagated to blockchain and the channel is left open. To pay each other, the parties create transactions from the multi-signature address. Once all transactions still pending in the chain have finalised, off-chain transactions can then be performed. When the channel closes, the final balance is recorded in the blockchain. 

Today, several companies are at the forefront of Lightning Network development. Blockstream, Lightning Labs and Acinq are just some examples of startups offering their own Lightning Network solution in order to issue their own digital assets through their network and instantly execute cryptocurrency transactions.

Not only are there new companies offering this service – increasingly more companies, which we could catalogue as traditional, are jumping on the bandwagon to implement their own payment systems. Here are some examples: 

  • Shopify, an e-commerce company, has an agreement with Strike to receive payments (via the Lightning Network) in bitcoin, as well as US dollars, from customers around the world. They hope to use this technology to lower fees and streamline international transfers. 
  • McDonald’s (a fast-food franchise) now accepts bitcoin in El Salvador through the Lightning Network. This has all been possible thanks to Stripe's association with Shopify, NCR and Blackhawk. As payments over Lightning Networks continue to grow, it is expected that more and more shops will accept bitcoin (BTC) micropayments. 
  • At the sovereign level, El Salvador's use of the Lightning Network for remittances was one of the main reasons why the country incorporated Bitcoin as legal tender. Remittances are an important component of El Salvador's GDP, so the country wants to lower costs for receiving such payments.

This technology, however, has its disadvantages, namely:

  1. Payments can only be made to users who are connected to a payment channel, i.e., the user must be active and connected to the channel. By contrast, traditional cryptocurrency transactions are not affected by this limitation. 
  2. The Lightning Network is a protocol that is still constantly developing. The fact that even its creators don't recommend using Lightning for transactions involving large sums of money is testament to this.
  3. The protocol limits the channel's liquidity for all cryptocurrencies supported by all parties. This is another situation that undermines high-value transactions, as it makes users to have to split their funds in order to have liquidity on normal blockchain and Lightning Networks.

To summarise, Lightning Networks pose a solution to a problem that not only affects the Bitcoin network (scalability), but also other cryptocurrencies and, what's more, it even has the potential to streamline and reduce costs for fiat-currency payments.

This article is for educational purposes only and does not reflect the opinion or strategy of Banco Santander, and in no way should be considered as financial advice.

Note: Cryptoassets are exposed to high risk of illiquidity and full loss or temporary unavailability of the capital invested, as they are highly speculative products that see highly volatile prices and huge fluctuations in valve. Cryptoassets are unregulated and may not be suitable for retail investors. Their prices are set in the absence of mechanisms to ensure their correct formulation, such as those that exist in regulated stock markets. On a similar note, their high dependence on technology can give rise to operational faults, cyberthreats and risks arising from holding cryptoassets under the applicable legal framework and credentials or passwords can be stolen or lost. Cryptoassets also entail the risk of fraud or money laundering. This means that cryptoassets may not fall under EU regulations and would therefore be unprotected, meaning that the capital invested may not be covered by the Deposit Guarantee Fund or the Investment Guarantee Fund. Any potential issues may, therefore, be rather costly to resolve.

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