The Lightning Network
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The Lightning Network
In recent weeks we have spoken a lot about smart contract platforms and layer 2 scaling solutions. Through the utility they provide, these networks will form the backbone of what has been dubbed the Internet of Value. We also believe that projects like Ethereum will help the Bitcoin Network scale; you can read about that here. However, how would a project like Bitcoin scale meaningfully in the absence of an established, Turing Complete smart contract platform? This is where the Lightning Network fits in.
What is the Lightning Network
Bitcoin's scalability problems are often cited as one of the core reasons it will fail. If it can't be used to purchase coffee, then what is the point of it all? Even though Bitcoin is so much more than that, it is what we hear most often.
Yes, this has been a problem for a while now, but never doubt the ingenuity and tenacity of humankind; through the Lightning Network and other similar projects, we have been presented with a solution.
The Lightning Network is what we call a layer 2 scaling solution. Because blockchains need to make a tradeoff between decentralisation, scalability and security when designed (they can only excel at two of the three), there exists the opportunity for projects to shine where others are weak. Bitcoin has placed its emphasis on decentralisation and security and therefore opened up the opportunity for other projects to focus on scalability.
The Lightning Network was first proposed in 2015 by researchers Joseph Poon and Thaddeus Dryja in a paper titled "The Bitcoin Lightning Network". They based the research on conversations Satoshi Nakamoto had with Mike Hearn regarding payment channels in 2013. The heart of what they wanted to achieve was cheap and fast transactions for the Bitcoin network. Currently, as it stands, transaction (or routing) fees can be as low as 1 Satoshi, which is 1/100,000,000th of a bitcoin, and there is no upper limit to the number of transactions it can process per second.
How Does it Work?
There are many different ways that one can go about achieving scalability within blockchain networks. To get an idea of the different ways, we recommend you give the following a read. Once done, let's determine where the Lightning Network fits. While not exactly a state channel as described in the article above it is very similar.
Firstly and the most important to remember is that the Lightning Network is not a blockchain. It is an overlay network built on top of the Bitcoin blockchain that allows users to set up payment channels to transact between one another off the Bitcoin mainchain. To create these payment channels, the Lightning Network uses Bitcoin smart contracts. These smart contracts are different to those of Ethereum as they are not Turing Complete; therefore, the scope of what they can do is more limited. However, what they can allow you to do is set up a bidirectional payment channel with others. This process begins with two parties locking up a certain amount of Bitcoin on the network; this effectively moves the bitcoin off-chain. Once done, leveraging the Lightning Network software, these parties can start transacting with one another indefinitely or until their funds run out. However, even if this happened, they could just top up their balance and continue transacting.
As the parties continue making payments between themselves, the Lightning Network keeps a record of the balances off-chain. This frees up space on the mainchain as usually, each payment would have to be recorded and propagated across all the nodes of the network, which takes time. However, with the Lightning Network, the Bitcoin network only needs to record two transactions, the initial creation of the payment channel and then the final settlement. There could have been hundreds or even thousands of smaller transactions that happened in between, significantly reducing the pressure on the mainchain.
But where is the real utility in a world where you can only settle between two nodes? Yes, you could keep one open for your local coffee shop, but that is extremely limiting.
The Lightning Network has attempted to solve this problem through routing. Through clever design and network effects, you can transact with someone else with whom you don't have an open node as long as you have a node in common. Say you are node A and want to send a payment to node C, but you don't have an open channel with them; however, you have an open channel with node B, and so does node C, you can make a payment to node C by routing through node B and paying a small routing fee. This holds true for an unlimited number of nodes; as long as they are connected in some capacity, they can transact.
The above example shows how vital network effects will be for the Lightning Network if it wants to provide real utility to its end users.
Where is it Currently?
There are several metrics that can help us understand the health and adoption of the Lightning Network. The number of nodes and channels and the capacity of the network. All which you would expect to see slowly increasing over time.
Number of Nodes
The number of nodes is important because to set up a channel, you first need a node. Some nodes can be private and have only a two-way payment channel between them, but if the user chooses, they can announce themselves to the network and become a channel through which others can route funds.
We have seen a consistent increase in the number of nodes on the Lightning Network, it is currently sitting just shy of 18 000 in total.
Number of Channels
The number of channels really points to the utility of the network. The greater the number of channels, the greater the number of payment gateways that are potentially available to the end-user.
We have seen a significant increase recently in the number of Lightning channels. We are currently sitting at just over 75 500 unique channels.
Lightning Network Capacity
When you set up a node and want to open a channel, you are required to commit a certain amount of bitcoin so that there is liquidity for that channel itself. The total amount of bitcoin that has been committed to open channels is what we call the network's capacity.
However, one thing that should be kept in mind here is that it is not the maximum amount of bitcoin that users can transfer over the network but rather the maximum amount that can be transferred at one time.
We have also seen the capacity of Lightning increasing over time. This increase in capacity will benefit people who need liquidity on top of the network and encourage others to use it as larger payments can be completed if needed.
Conclusion
The Lightning Network has started becoming a viable layer 2 scaling solution for Bitcoin. Yes, it isn't as secure as the mainchain, but over time we expect to see people leveraging the Lightning Network or another similar project for their smaller day to day payments. You can almost imagine it is a savings vs spending account. You will keep the bulk of your wealth or savings on the mainchain and top up your spending wallet that sits on the Lightning Network. With the momentum and speed at which these second-layer solutions are building out, it will only be a matter of time before you can use your bitcoin to get that coffee everyone has been so preoccupied about.
Notable Articles and News Stories This Week:
Bank of England and UK Treasury to Assess Case for a CBDC Next Year
The Bank of England and the U.K. Treasury will begin a consultation next year to assess the case for a central bank digital currency (CBDC).
Should it conclude that there is a case for a digital pound, the earliest that one could be rolled out is the second half of the decade, the Bank of England announced Tuesday.
The consultation will explore design features, benefits and implications for users to determine whether a CBDC that is operationally and technologically robust can be developed.
The announcement of the consultation follows the formation of two forums to explore the issue. The members were named in September and included Asos, PayPal, Spotify, Mastercard, Visa, HSBC and Standard Chartered.
Read more about it here
European Commission Urges Members to Agree on Crypto Regulations
The European Commission, the executive branch that proposes legislation for the European Union, is urging its members to agree on its proposed Markets in Crypto Assets (MiCA) regulations this autumn, according to statements by the EU commissioner for financial services during a web forum Wednesday.
Commissioner Mairead McGuinness said that the commission is also hoping to finalise its proposed regulatory sandbox for financial products based on distributed ledger technology (DLT) by the end of the year.
“Crypto assets are evolving fast, enabling homegrown firms to enter the market, while also attracting retail investors,” McGuinness said. ”It is our policy and our duty as policy makers to put sound rules in place as quickly as possible.”
Read the full story here
DEXs Growing Faster Than CEXs but Binance Still Sees 171M Visitors in a Month
A new Chainalysis report shows that the number of decentralised exchanges (DEXs) is growing faster than all other types of crypto exchanges. But Similar Web data shows centralised exchanges are far from unpopular, with Binance seeing 171 million visitors in October.
Chainalysis published a report on crypto exchanges on Nov. 11 and provided an analysis by breaking the exchanges down by their business models including DEXs, CEXs, over-the-counter (OTC) brokers, derivatives platforms and high-risk exchanges with minimal know your customer (KYC) requirements.
According to the data, the number of DEX’s between Q1 2019 and Q3 2021 increased more than 100% to sit at around 205 as of June this year. In comparison, the number of CEX’s temporarily increased from around 100 to 120, before dipping back to the 100 region within that time frame.
Read more about the report here
Whilst we all have the option to look, to seek to understand, it’s often easier not to. Bitcoin, Ethereum and distributed ledger technology are complex systems that require significant due diligence. At Etherbridge, we aim to lower the barriers to understanding this fast-growing digital economy.
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This is not financial advice. All opinions expressed here are our own. We encourage investors to do their own research before making any investments.