While the blockchain is a game-changing technology, Bitcoin as its earliest iteration of a cryptocurrency experienced some limitations as an alternative to fiat money. One of these limitations is the time it takes to reach consensus on a transaction on the Bitcoin blockchain. On average, it takes 10 minutes to process one Bitcoin transaction and the network is limited to seven transactions per second, which means that Bitcoin will not be able to scale enough to keep up with a typical transaction network like Visa.
This scalability limitation is one of the problems that needs to be solved if Bitcoin wants to achieve mass adoption as a currency. The Bitcoin Lightning Network is a payment protocol that operates on top of the Bitcoin blockchain as a second layer. Lightning Network is the most promising solution to the scalability and transaction speed problems facing Bitcoin today.
Although other cryptocurrencies and blockchain projects may have solved these problems, none of them has the widespread market adoption of Bitcoin.
After the speed and scalability limitation of Bitcoin became obvious, a solution was proposed in 2017 to use a function called Segregated Witness, or SegWit. SegWit segregates the signature (the witness) portion of a Bitcoin block from the portion containing the transaction data. In effect, this allows each block in the Bitcoin blockchain to carry more information (or carry information more efficiently).
More importantly, SegWit allowed for off-chain systems to be added to the Bitcoin network. This allows the Bitcoin network to effectively continue unchanged, while new processes are added on a second layer which is reconciled with the Bitcoin blockchain later on.
The Lightning Network opens up a channel between two users and allows them to make transactions (via smart contracts) with each other without settling their balances to the Bitcoin blockchain until one of the parties closes the channel. To open a channel, a user must commit an amount of Bitcoin in a funding transaction called a Hash Time Lock Contract (HTLC) on the Bitcoin blockchain. This is pretty much like how someone has to deposit money in a bank account in order to transact with a debit card connected to that account.
On top of this, Lightning Network can open channels between channels, forming networks of channels. This enables transactions to be made between multiple users on the Lightning Network as long as a path can be mapped between them, much like how the Internet functions.
The benefit of this second-layer network is that transaction costs go down and transaction speeds go up. Transaction costs drop because tens or even hundreds of Lightning Network transactions can be settled by making a single Bitcoin transaction. This also means that thousands of transactions can happen simultaneously, rather than just seven per second.
Since the Lightning Network White Paper was first published in 2016 by Joseph Poon and Thaddeus Dryja, working versions of the Lightning Network protocol have been rolled out. Adoption is relatively low compared to the overall Bitcoin market, although the number of Lightning Network nodes grew substantially, doubling to 10,000 between 2020 and 2021. The amount of Bitcoin committed to Lightning Network via HTLC funding transactions has also increased over time and stood at 1,380 BTC as of June 2021.
Most interestingly, if other cryptocurrencies also adopt Lightning Network as a Layer 2 protocol, there is the potential for future interoperability of multiple cryptocurrencies.
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