At the Beginning
As with every new technological breakthrough; Bitcoin and the Blockchain have areas that many users feel could be improved. Among those are time and fees.
But How Does It Work?
In order for you to better understand those issues let me explain how this whole system works. When Bitcoin is transferred from one wallet to another a small "miners fee" is added to that amount. This fee can be adjusted by the sender in order to get a faster transfer time. This time, even with a small fee, can be minutes, to hours. In some cases where there is heavy blockchain traffic, this transfers can potentially take days.
Why Does It Take So Long To Make An Electronic Transfer?
To understand that you must understand the very nature of the blockchain itself. When you initiate a transfer that sends a message into the waiting pool until it is included in a block by a miner. Once included in a block, every transfer that coin has gone through since it was mined is backtracked. This process is what creates the literal chain of blocks as each block is confirmed by tracing every transaction's history before the current block is added to the existing chain. Hence; the blockchain is born.
The algorithm that builds the blockchain becomes harder with every block that is confirmed to the chain. So, the longer the chain, the longer the algorithm. So, as more and more blocks are added to the blockchain, it takes more time to confirm each.
Since each transaction is picked up by the miners in accordance with the fee attached (larger fees are picked up quicker) the price of sending a transaction will be costlier if you need those funds sent faster. Therein lay the issues of Bitcoin transfers.
How Is The Lightning Network Solving Those Issues?
To solve these two issues Joseph Poon and Thaddeus Dryja created the Lightning Network (called LN for short).
What is the Lightning Network?
Some people around the cryptosphere have been murmuring about the "Lightning Fork". That is simply not the case here. Think of the Lightning Network like a peer to peer crypto-PayPal with quick, easy transfers back and forth between two users in their own dedicated payment channel.
How Does This Work?
Let's look at the story of Bob and Tom. These guys do business together regularly, sending frequent payments back and forth. So, Bob creates a website for Tom. Tom pays Bob $ 400 worth of bitcoin plus another $ 150 to set up everything on a server and get it running. Along the way something happens with the server deal; so, Bob sends back the $150. A few days later Tom decides he wants a big revision to the site and sends Bob $ 250 more to get that done. On and on go the payments between Bob and Tom; week after week; month after month.
At the end of the year, Bob sits down to do his taxes only to find out that he has lost hundreds of dollars in miners fees. Sure, the IRS (Internal Revenue Service) lets him write off that loss. But, still, that's a lot of extra costs that are not really figured into the business plan.
Enter the Lightning Network
Bob discovers this Bitcoin miracle and talks to Tom; whereupon they set up a payment channel between themselves. In essence, a Lightning Network payment channel is really a multisig wallet where both participants deposit funds. Once those deposits are made a smart contract kicks in defining the rules. This contract records the transactions between Bob and Tom for the time period set when the channel was opened. That is s pretty techie if you are not familiar with the terms. So, let us simplify it a bit.
Bob and Tom each put $ 1,000 worth of bitcoin into a shared wallet system. Those two deposits are recorded onto the BTC blockchain, just like any other Bitcoin transaction; each was charged a mining fee, just like any other transaction. Those funds are then locked in place for a certain time period. Let's say this channel is set for a month. Now, here is where Lightning Network takes the sting out of repeat payments...
For that month the payment channel records transfer between Bob and Tom. In the beginning, the contract allocates the original $ 1,000 to each of them. As the transactions proceed, the smart contract behind the payment channel adjusts that amount to reflect the true nature of that balance. Then, when the payment channel expires the payout is made according to the final balance.
If the parties decide to settle the account prior to the end of the time frame announced they are free to do so; which pays out to each participant in accordance with the last balance recorded by the payment channel. Only when the channel expires (or is canceled) is there a new blockchain entry; and therefore a new mining fee for each of those two transactions. Any subsequent transaction within the Lightning Network payment channel is not charged such a fee as there is no blockchain entry.
So, by withholding blockchain entries, the Lightning Network has reduced fees, reduced wait times for transfers, and reduced blockchain congestion for everyone. Brilliant idea; without a fork.
Good luck on your crypto journey. Happy HODLing!!! Thanks for joining us.
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