The first public comment made on Bitcoin after it was first proposed by Satoshi Nakamoto in 2008 was by James A. Donald. It was “the way I understand your proposal, it does not seem to scale to the required size”. A decade later, his words still hold true and the problem remains the same.
By scalability, we mean that Bitcoins transaction processing speed, i.e., 7 transactions per second, cannot efficiently accommodate the number of transactions happening on the network. This results in delayed transactions and high transaction fees.
To cater to the scalability issue of Bitcoin, the concept of Lightning Network was proposed. It advocates that it is not necessary to keep a record of every single transaction that happens on Bitcoin.
It adds an additional layer on the Bitcoin’s Blockchain which serves as the platform that allows users to establish payment channels between two parties. There is no time limit imposed on these channels and because of the involvement of only two parties, the transaction will be instant. Also, the fees charged will be negligible or non-existent.
It will be better understood with the help of an example. Take for instance two people by the name X and Y who have a requirement of quick and cheap money transferring platform. They have to transfer funds quite often, maybe because they are relatives, a couple or do business together. To meet their needs, they set up a channel on Lightning Network.
The first step is to create a multi-signature wallet which is accessible by both the parties using their respective private keys. Following this, both the parties deposit a mutually decided number of Bitcoins in the wallet, like 4 BTC each.
This allows them to perform limitless transactions without any hassle. These are basically redistribution of funds by transferring ownership rights from one party to another. For instance, if X needs to transfer 2 BTC to Y, then he will just transfer the ownership right of existing BTC to Y. It is confirmed when both the parties sign an updated balance sheet using their private keys.
This implies that a real transfer of funds never takes place until the channel is closed. The algorithm then distributes funds according to the latest updated balance sheet. In this case, if the account is closed after this transaction then X will get 2 BTC, while Y will get 6 BTC.
Also, it is only after closing the channel that the transaction is updated on Bitcoin’s Blockchain with the information of first and final balance sheet. This way, users can perform multiple transactions and record them as a single one.
If widely adopted, this technology will not necessitate setting up dedicated channel to transfer funds to a single person. Instead, it’ll allow fund transfer to different people using the channels with people one is already connected with. The system will be capable of automatically detecting the shortest route.
However, it is to be noted that this system doesn’t provide the security of original Blockchain network and it’ll mostly be used for small transactions. Larger transactions that require high level of security which is provided by the decentralized network will probably still occur on the original layer.