By: Shane Neagle

Pseudonymous Satoshi Nakamoto intentionally designed the Bitcoin network to prioritize robust security over performance. As a result, Bitcoin’s proof-of-work algorithm exerts energy cost when each Bitcoin transaction happens, imposing cost on spam and double-spending.

Altogether, this leads to a peer-to-peer network that can process up to 7 transactions per second, which are then bundled into blocks and added to the blockchain every 10 minutes. Needless to say, this is light years away from Visa’s 24,000 tps.

But, that’s exactly where the Lightning Network comes in.

Is It Bad that Bitcoin is a “Gen 1” Blockchain?

In May, the now-notorious fraudster Sam Bankman-Fried said that the “Bitcoin network is not a payments network and it is not a scaling network,” to the Financial Times. Such a statement reflects the establishment view, especially for ESG-oriented investors. SBF based that qualification on the fact that Bitcoin (BTC) is produced with a proof-of-work network, instead of proof-of-stake network.

When viewed in that light, it is certainly true that the Bitcoin network is not cost-effective, given that it consumes as much energy as the country of Sweden. After all, we’ve seen that Ethereum reduced its energy consumption by ~99% when it transitioned from proof-of-work to proof-of-stake through the Merge in September of 2022. However, that’s only one metric by which we can judge if something is cost-effective.

What is the implication of securing a blockchain network with capital (stake) instead of electricity (work)? One doesn’t have to dig deep to see it. For example, Tron founder Justin Sun sought the help of multiple centralized exchanges (CEXes) to buy the Steem network. He then used Steem to influence users so they can deploy their capital (stake) to pass his Tron proposal.

In raw numbers, Kraken report delivered the minimum capital required to take over 33% of PoS network validators to render the network from decentralized to centralized:

• Solana - 27 validators at a $4.2 billion stake
• Algorand - 17 validators at a $351 million stake
• Avalanche - 31 validators at a $1.3 billion stake

Of course, that report was in August, so the minimum takeover requirements are much lower in November 2022. Going back full circle to Sam Bankman-Fried’s statement, the Bitcoin network alone may not be a scaling network. Does it really need scalability?

The simple answer is yes. Cryptocurrencies such as Bitcoin are growing in popularity due to their long-term investment thesis, as seen through the inclusion of digital assets in various long-term investment products such as IRAs. Yet recall that Satoshi’s original vision was a system of ‘electronic cash’ for ‘online payments’.

Can Bitcoin handle payments right now? Well, not really. And this is precisely where the need for scalability comes into play.

What is the Lightning Network and How Does it Work?

Just as Ethereum has its scalability solutions, such as Polygon, Arbitrum or Optimism, Bitcoin has the Lightning Network (LN). So far, Lightning Labs received $82.5 million across four funding rounds to scale up Bitcoin for mass global adoption as a digital currency that can be used for payments.

That is to say, the Lightning Network makes Bitcoin payments near-instant, low-energy, and low fee. As a separate layer 2 network, the Lightning Network interacts with Bitcoin as a layer 1 network. Just like the Bitcoin network, the Lightning Network consists of nodes. Each Lightning Node has a built-in hot wallet.

However, Lightning Network nodes also have built-in layer 1 (Bitcoin) wallets. Therefore, for people to use the Lightning Network, they have to fund this wallet with BTC, locking the funds in. This is necessary to open a Lightning Network payment channel. From that moment on, the recipient can request an invoice on the other side of the channel.

When people want to send BTC, they can keep the channel open as long as the wallet is funded with BTC. The effect in the real-world is a Visa-like performance with negligible transfer fees.

This is possible because LN circumvents Bitcoin’s slow mainnet. All the transactions committed through the LN payment channel are added to Bitcoin’s mainnet only when the payment channel is closed. That’s because BTC funds are moved from LN wallet to layer 1 wallet when the channel closes.

All the committed transactions in the channel are then bundled up as a single transaction that is much easier for Bitcoin miners to process. Consequently, the transfer performance is entirely dependent on LN, instead of the “gen 1” Bitcoin network.

Is Lightning Network Secure?

Bitcoin is known for never having been hacked. The Lightning Network doesn’t detract from that track record because it uses Bitcoin’s mainnet for authentication and security. Every time a transaction goes through the LN payment channel, the node uses a multisig transaction, signed by both parties.

This way, both parties broadcast the state of their payment channels, updating the balance of allocated funds. However, this also means that the other party has access to the channel. If one party is malicious and closes their channel while the counterparty is offline, they can then pilfer bitcoins from the active wallet.

Moreover, there are routing fees involved when opening a new channel. This can create some level of inconvenience because all the bitcoins have to be pulled and used to refund a new channel, instead of leaving a small amount of BTC to keep the channel open.

Nonetheless, Lightning Network adoption is steadily growing. Since January 2021 to present, the number of LN nodes has increased by 105%, to over 17,000 nodes. This results in a capacity to process $83 million worth of daily BTC transfers.

The Lightning Network is gaining popularity as well. With established names such as Cash App as well as Robinhood and Strike integrating the LN, it seems as if the foundational pipelines for Bitcoin’s payment infrastructure are currently being laid out.