What Is the Lightning Network?
Crypto Basics

What Is the Lightning Network?

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Created 1yr ago, last updated 8mo ago

CoinMarketCap takes a look at the functionality, development, use cases and risks of the Lightning Network, a layer-2 payment protocol on top of Bitcoin.

What Is the Lightning Network?

Table of Contents

Bitcoiners and naysayers love to argue whether BTC is a store of value or a medium of exchange, or whether it is both or neither.
Bitcoin's supporters praise the network for the ability to embody a store of value and a medium of exchange simultaneously. But at the same time, Bitcoin's critics slam it for the exact same reason: how could a store of value ever also be a medium of exchange that you'd want to trade?
The Lightning Network may be the solution to this dilemma. It is often lauded by Bitcoiners as the silver bullet for the network's shortcomings and as often ridiculed by critics for bordering on irrelevancy. In this article, we look at:
  • What is the Lightning Network and how does it work?
  • Why do we need the Lightning Network and how is it different from Bitcoin?
  • The Lightning Network’s development thus far.
  • Lightning Network’s use cases.
  • Lightning Network’s risks and problems

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What Is the Lightning Network?

In short, the Lightning Network is a layer-2 technology on top of Bitcoin. It attempts to scale Bitcoin's use case as a medium of exchange and is mainly being developed by Lightning Labs. The technology behind it was established by researchers, Joseph Poon and Thaddeus Dryja, who published a white paper about the Lightning Network on January 14, 2016.

How Does the Lightning Network Work?

Here's a non-technical explanation of the Lightning Network's functionality:
The Lightning Network (LN) opens a channel between two parties that want to process payments. This payment channel has to be funded with liquidity in Bitcoin. Liquidity can be held by the two parties or provided externally. Transactions are settled in the payment channel only and are not broadcast to the network, thus incurring no network fees. Once the payment channel is closed, the "final tally" is broadcast to the Bitcoin network, and the balance is settled.
The Lightning Network is like putting something on the cuff before settling it on the Bitcoin network. The only difference is that Bitcoins transacted on the LN do move between accounts. There is no debt-based settlement — all the liquidity required for transactions has to be provided. Parties that attempt theft are penalized and prevented from broadcasting a false network state.
The LN also allows for payments via two parties that do not have a direct payment channel open with each other. These multi-hop channels route liquidity through routing nodes, which get a small transaction fee. The network automatically selects the cheapest route. Transaction fees are a mere 0.1%.
You can find a more detailed and technical explanation of the network's functionality in the Arcane Research paper called "The State of Lightning Volume 2."

Understanding the Difference Between Bitcoin vs Lightning Network

Technicals, shmecnicals! But what is the big-picture rationale for the LN?

Here's a short point-by-point explanation:

  • Bitcoin has scaling issues. It is not designed to rival a payment network like Visa. That is because Bitcoin optimizes censorship resistance and decentralization over speed and efficiency.
  • Bitcoin is designed to rival a settlement layer like Fedwire (payment rails of the Federal Reserve) — only in a more decentralized and censorship-resistant form.
  • In traditional finance, commercial banks use Fedwire. Retail customers use payment networks like Visa, Paypal, or Revolut.
  • In "Bitcoin finance," payment providers build on the Lightning Network and settle on the Bitcoin network. Retail customers would not settle transactions on Bitcoin because that is not its primary function.
There are obviously other on-chain solutions for transactions, like using stablecoins on Ethereum or other blockchains. However, most of these chains, including Ethereum after the Merge, do not optimize for being a decentralized payment network. Ethereum's use case is a "decentralized world computer," while other blockchains target GameFi or DeFi as their presumptive main utility.
The Lightning Network, however, could (in theory) offer a reasonably decentralized, cheap and scalable solution for improving peer-to-peer payments:

Lightning Network Development

That sounds all fine and dandy, but there's one big problem with the Lightning Network:

Its development is progressing at a snail's pace.

A frequent criticism of the LN is that its transaction volume is trivial, especially compared to DeFi-related activity. For instance, Lyn Alden quotes 230,000 custodial WBTC on Ethereum, while the LN has less than 5,000 Bitcoins on its public channels.
However, payment volume has grown 410% year-on-year and is up significantly, taking the bear market conditions into account:
Importantly, payments excluding trading services are also growing rapidly (+480% YoY):

Network growth is up across all metrics: payment volume, BTC and USD public capacity, nodes and public channels.

It's worth noting that growth is understated since we cannot observe private channels and invisible nodes. Much of the increase in demand can probably be traced back to a supply-side push — the LN is now supported by Chivo Wallet (the official BTC wallet in El Salvador) and Cash App. More than 80 million users have access to the Lightning Network (although not all of them actually use it).
48% of the payment volume on Lightning is private payments, and more than half of all transactions are micro rewards. Though small in volume, there is a growing demand for this use case and individual payments on the LN.
Unlike DeFi, the Lightning Network is all utility and no speculation. Almost all Wrapped Bitcoins on Ethereum are used for trading purposes, while more than two-thirds of BTC volume on Lightning is used for utility-related payments. Thus, comparing Bitcoin-related TVL on Ethereum and Bitcoin volume on the LN is a faulty comparison.
Put simply, Lightning is offering a solution for a problem with a tiny but rapidly growing demand: micro rewards and peer-to-peer crypto payments.

Lightning Network Use Cases

The current Lightning Network ecosystem stretches across several products and services: nodes, wallets, payment processors, finance and trading apps, reward apps, gaming-related rewards and social and streaming apps.

However, considering Lightning's currently limited volume, it is worth looking at potential future adoption angles that could blow up the demand for Lightning.

The Creator Economy

The "creator economy" has been hyped a lot as a major Web3 use case of the future. But real utility from "web3 social media" is still close to non-existent. Lightning could play an essential role in changing this status quo and facilitate value transfers to creators directly.
The problem with current social platforms, like Twitter, Instagram and YouTube, is that content creators generate all the value but receive only a fraction of the revenue generated from it. Sponsorship deals or even more direct monetization options like social shopping and tipping features are imperfect solutions because creators still remain at the mercy of centralized platforms allowing them access to monetization options.
Twitter's move to incorporate Lightning as a tipping feature is a step in the right direction. But a much better solution would be new platforms that move away from ad-based monetization, which maximizes platform time and thus rewards "shock content," to a model rewarding creators’ creativity. It would allow direct tipping with a minimal take for the platform, whose job would be to promote long-tail content over outrage bait.

In short, more rewards for smaller creators and a healthier social media landscape.

Remittances and USD Payments Settled on Bitcoin

Remittances were a darling use case of Bitcoiners. After all, Western Union and its companions take an outrageous cut for cross-border payments, right?

Turns out that crypto remittances are nothing but a rounding error in the grand scheme of things. Users find crypto too difficult to use still. Most importantly, nobody wants to deal with holding the hot potato that is Bitcoin volatility. Never mind that crypto on/offramps are a pain, too.

The solution?

Using the Bitcoin network for settlements but transferring USD.
Users care mostly about cost and convenience. Whether the payment rails are built by fintech, banks or crypto companies is secondary. Companies could build remittance payment railways on Lightning and provide the on/offramp necessary to ensure a smooth experience.
That would obviously require viability studies and a lot of regulatory hassle. "Underbanked regions" like Sub-Saharan Africa are not as underbanked as it seems — 70% of the world's mobile money market is in Africa. However, accessing USD liquidity would be interesting for citizens of countries with quickly-inflating currencies. Of course, governments would not like that one bit and fight back with their own CBDCs like Nigeria's eNaira.

But it's a clear use case and is already being used by El Salvador (though their version needs some improvement).

Microtransactions and Microrewards

The plight of BTC is that it wants to square the circle by being a store of value and a medium of exchange at the same time.

Essentially, you want to use the Bitcoin network but save bitcoins as crypto. That means a third party needs to provide an offramp to go back into fiat (like centralized exchanges), or we need to find a use case where you accumulate the coins you receive.
Microrewards would be an example.
A primitive version of that is a crypto faucet. The next evolution of the freemium model may well be paying users directly for their time through microtransactions when they view ads. You accumulate sats through Lightning, while ad companies receive your valuable attention.

Lightning Network Risks and Problems

However, Lightning comes with a lot of problems and banana skins on the way to potential mass market adoption.

Market Competition

Lightning cannot conclusively answer why anyone would use its network over existing solutions like credit card companies, fintech or even stablecoins. To re-iterate:

Users care almost exclusively about cost and convenience.

While Lightning may (in theory) be cheaper than its rivals, it's anything but convenient at the moment. And without fundamental demand for its competitive advantage (cost and speed), merchants and users will have little reason to switch.

The solution to that is carving out its own "blue ocean" like microrewards or creator tipping. Successful implementation of Lightning as a tipping service would establish a proof of concept and allow the network to penetrate other use cases.

Lack of Supply and Demand

All new networks face a chicken-and-egg problem:

No new users without merchants offering the new product, but no merchant has an incentive to do so if there isn't demand from users.

Take mobile payments for the "unbanked:" M-PESA already has a grip on the African market. A new competitor building on Lightning needs to have a clear competitive advantage and, more importantly, a profit motive to do so. But building on the Lightning Network comes with technological, regulatory and liquidity challenges. Put differently, if it was so easy, companies would be already doing it.

Government Interference

Even though the citizens of emerging market countries may welcome dollar access and stable payment rails, their governments do not.

In "Debunking the Bitcoin Nation-State Theory," we explored why authoritarian governments have little incentive to endorse BTC-based solutions (TLDR: they give up control). CBDCs are competitors to crypto that governments can control — and unlike cryptocurrencies, governments can coerce their citizens into using their solutions through taxation and goodies like tax breaks.

Look at it this way: a CBDC has a central entity (the government) that can force its customers (taxpayers) to use its payment network (a CBDC/fiat). It can also stifle its competition (Bitcoin/Lightning), which has no such central entity enforcing its adoption and, for the most part, does not even have a profit motive to do so. In that way, Bitcoin's (and Lightning's) biggest strength is also a major weakness.

Conclusion

In theory, the Lightning Network is great. However, it comes with a ton of practical problems and faces stiff competition from the private sector and governmental solutions.
Lightning is definitely worth keeping an eye on, especially considering its unique potential use cases. It is mostly utility and almost no speculation, which probably contributed to its slow development. The bear market may be a blessing in disguise but don't bank on quick successes.
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