The Lightning Network: Layer 2 Scaling Solutions for Proof of Work

Leading cryptocurrencies like Bitcoin currently function through the use of a consensus mechanism known as Proof of Work. While decentralized and highly secure, this mechanism faces significant issues when it comes to meeting the needs of a growing number of users. The Lightning Network is one emerging solution that aims to allow PoW cryptocurrencies to be fast, affordable, and less resource exhaustive. It's also just one of a group of "scaling solutions" that are getting more attention as interest in crypto grows.

Following on from our previous guides in our "crypto basics" series, this article provides an explanation of the Lightning Network that is suitable for people of all experience levels.

Why cryptocurrencies like Bitcoin have trouble scaling

As we covered previously, the two major consensus mechanisms in the landscape today are Proof of Work (PoW) and Proof of Stake (PoS). While variations and other approaches do exist, PoW and PoS are the most widely deployed. They are used by the majority of popular cryptocurrencies.

Proof of Work in particular, however, struggles to operate effectively and efficiently when a network is under stress. For instance, when comparatively fewer people are using the Bitcoin network, transactions are extremely cheap and fast. During times when Bitcoin is particularly popular, however, transaction fees skyrocket and transaction speeds can become prohibitively slow.

As part of the core design of Proof of Work networks, every single transaction is stored in blocks that are a fixed size. In order to be added to the blockchain, these blocks of transactions are then confirmed by a giant worldwide pool of devices which are constantly running complex calculations in a process known as cryptocurrency mining.

While this design makes cryptocurrencies like Bitcoin extremely secure, they also mean that Proof of Work cryptocurrencies consume a significant amount of electricity, as mining can be extremely resource exhaustive. While proponents behind some cryptocurrencies like Ethereum aim to switch the network away from Proof of Work in favor of Proof of Stake to remedy these concerns, others have turned to scaling solutions that can improve the efficiency of Bitcoin and similar digital assets.

How layer 2 off-chain solutions make transactions faster and cheaper

An important term to understand in the battle to make cryptocurrencies better for users and the environment is the term “off-chain.” The Lightning Network (LN) is the most well known example of a layer 2 off-chain solution, but it is far from the only example of a protocol that aims to make PoW cryptocurrencies better equipped to handle high volumes of trading activity.

Take Bitcoin’s implementation of Proof of Work as an example. Here, every single transaction must be included in a block of transactions and added directly to the blockchain itself. This means that transactions slow down and cost more to confirm when the network is congested by lots of transactions occurring at once. But what if there was a way to handle some of these transactions outside of the blockchain?

That’s where off-chain scaling solutions get their name. They essentially create only two transactions on a blockchain in order to handle multiple individual transactions outside of the blockchain.

For instance, if I wanted to send someone BTC using the Lightning Network, it would create an opening transaction on the blockchain. This opening transaction would then permit access to what’s known as “layer 2”. While the Bitcoin blockchain operates as usual, this second layer opens a channel "on top", which can handle a bunch of transactions directly between you and the person you want to pay. Once these are done, you only need to create a closing transaction on the blockchain in order to confirm all of this activity in one batch.

So, while a set of traditional on-chain Bitcoin transactions might look like this:

[Bitcoin transaction 1] Adam sends you 0.1 BTC.
[Bitcoin transaction 2] You send Adam 0.05 BTC.
[Bitcoin transaction 3] Adam sends you 0.05 BTC.
[Bitcoin transaction 4] You send Adam 0.1 BTC.

Off-chain Bitcoin transactions, such as those enabled by the Lightning Network, can instead look like this:

[Bitcoin transaction 1] Opening transaction
Adam sends you 0.1 BTC.
You send Adam 0.05 BTC.
Adam sends you 0.05 BTC.
You send Adam 0.1 BTC.
[Bitcoin transaction 2] Closing transaction

We created four separate transactions on the Bitcoin blockchain in the first example, and had to pay a fee and wait for each individual transaction to be confirmed. Using the Lightning Network protocol on top of Bitcoin, however, we created just two transactions by doing the same thing off-chain. If we apply this example to cases where you might send thousands of transactions, being able to handle most of them on a second layer makes the actual Bitcoin blockchain less congested and thus reduces transaction fees, costs, and energy usage.

The Lightning Network

The Lightning Network is currently the most often discussed layer 2 scaling solution for Proof of Work cryptocurrencies. As we illustrated in the previous section, it allows a group of transactions to be handled off-chain, rather than handling each individual transaction directly on the Bitcoin blockchain.

While the Lightning Network was first outlined by Joseph Poon and Thaddeus Dryja, it is not the sole product of any individuals or groups. Like Bitcoin itself, many different programmers and companies are currently working on their own ways to work out any remaining kinks in order to enable its widespread adoption. Further, the Lightning Network is not exclusive to Bitcoin and can be used with other Proof of Work digital assets.

This prominent scaling solution is currently in ongoing development, though it's already being employed by some businesses and users around the world. One of the most watched use cases at the moment is occurring in El Salvador, where the country aims to deploy the Lightning Network in order to facilitate everyday Bitcoin spending. Further, as CoinDesk reported, the Lightning Network broke a milestone in August 2021, with 25,000 devices active in the network for the first time.

Importantly, while “layer 2” is often mentioned in the context of the Lightning Network, the terms are not synonymous. Various other protocols, such as the Liquid Network for Bitcoin and Plasma and the OMG Network for Ethereum, also function as layer 2 scaling solutions.

Ultimately, one of the most important lessons to take away from the development of layer 2 solutions such as the Lightning Network is the fact that cryptocurrencies are still relatively new and actively improving. While it is true that Proof of Work digital assets like Bitcoin currently become less appealing for everyday transactions when the network is under heavy use, a decentralized arena of hard working programmers and startups are constantly working to develop solutions that can take crypto to the next level. The Lightning Network is merely one of those exciting developments to watch.