As the world's first cryptocurrency, Bitcoin (BTC) introduced a groundbreaking design that set the standard for decentralized digital assets. However, it’s not without limitations – slow transaction speeds, higher-than-average fees, and other challenges that developers must overcome for BTC to become practical for everyday payments.

Enter the Lightning Network, a second-layer protocol that addresses Bitcoin’s scalability issues by enabling off-chain transactions and reducing congestion on the main blockchain. The result? Near-instant payments with minimal fees.

So, how does the Lightning Network work, and can it take Bitcoin to the next level? In this guide, we’ll tell you everything you need to know.

What is the Bitcoin Lightning Network? 

The Bitcoin Lightning Network (often referred to as the LN) is a second-layer protocol built atop Bitcoin's base blockchain, classified under "layer 2 (L2) scaling solutions." Its primary purpose is to enhance Bitcoin's scalability by enabling faster and cheaper transactions through offchain payment channels. By processing high volumes of transactions offchain, the Lightning Network reduces the computational load on Bitcoin's blockchain, helping improve efficiency.

The Lightning Network supports billions of transactions per second (TPS) for less than a penny per transfer, making it highly effective for applications like microtransactions (small, frequent payments) and global remittances (cross-border money transfers). Conversely, Bitcoin’s base layer processes only seven TPS and often incurs transaction fees of several dollars, especially during network congestion.

Developers Joseph Poon and Thaddeus Dryja introduced the concept for the Lightning Network in 2015 in their white paper, "The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments." Following its release, Poon and Dryja cofounded Lightning Labs to lead the protocol’s research, development, and funding efforts.

In 2018, the Lightning Network officially went live and has since grown steadily, introducing upgrades and expanding its integrations. Today, it’s supported by wallets like Exodus and Strike, fintech apps such as Cash App (which integrated the Lightning Network in 2022), and leading centralized exchanges (CEXs) like Kraken, Coinbase, and Bitfinex. 

How does the Lightning Network work? 

The Lightning Network uses advanced cryptographic technologies and smart contracts, but a simpler way to think about it is as a network of payment channels that function like digital debit accounts. To use the Lightning Network, users open a channel through a compatible crypto wallet, which involves creating a multisignature wallet that requires multiple private keys to authorize transactions. They then deposit Bitcoin from the main blockchain into the channel, allowing for fast, low-cost, off-chain transactions. When the channel is closed, the final balance is recorded on the Bitcoin blockchain.

After opening a Lightning Network channel and depositing BTC, users can transfer Bitcoin through their channels as often as they like. The Lightning Network’s "multi-hop" routing system sends payments via intermediary channels, enabling user transactions without requiring direct connections. This reduces the need for individual links between every participant, enhancing the network's efficiency and accessibility. 

For example, if User A wants to send BTC to User C but only has a direct connection to User B, the Lightning Network’s multi-hop system can route the payment through User B’s channel to reach User C. As the Lightning Network expands with more users and channels, even a single connection can facilitate many payments across the entire network.

Now, back to the debit account analogy: Although the BTC transferred on the Lightning Network represents real Bitcoin, transactions occur off-chain within the network’s payment channels. Until a user closes their payment channel, the BTC in their Lightning Network account functions like a balance in a debit account, ready for instant transactions. Users can withdraw their BTC at any time by closing their channel, at which point the final balance is recorded on Bitcoin’s main blockchain ledger.

Are there drawbacks to the Lightning Network? 

While the Lightning Network resolves many of Bitcoin's scalability challenges, it’s not without its flaws. Here are a few of the more prominent issues developers are working to address:

Centralization concerns

Over time, certain nodes (or "hubs") on the Lightning Network could accumulate a disproportionate share of liquidity and traffic, granting them significant control over BTC flows on the network. If too much influence is concentrated in a few node operators, the Lightning Network may become more susceptible to risks like transaction manipulation or censorship.

Channel jamming and route probing attacks

The Lightning Network’s distributed node network is vulnerable to specific attack types like "channel jamming” and “route probing.” Channel jamming is when attackers clog payment channels with incomplete or fake transactions, hindering legitimate payments. Route probing involves mapping network activity through small targeted transactions, potentially allowing attackers to spy on user activity.

Smart contract vulnerabilities

The Lightning Network depends on smart contracts to facilitate payment channels and trustless transactions. However, poorly written or outdated code introduces security risks. Bugs in these contracts could allow bad actors to prematurely close channels, steal funds, or disrupt the flow of payments.

Limited adoption and liquidity

Despite reaching 5,000 BTC in deposits by 2022, the Lightning Network is still in its early stages with relatively limited usage compared to other blockchain technologies and decentralized applications (dApps). Many merchants, exchanges, and service providers still don’t accept Lightning Network payments. Also, lower liquidity across channels can complicate routing, leading users to seek alternative payment methods.

How to get started on the Lightning Network 

As more platforms integrate with the Lightning Network, more people are finding it easy to open their first payment channel and transfer BTC to pay for everyday purchases. Here’s how to get started:

1. Set up a Lightning Network-compatible wallet: Start by choosing a wallet that supports the Lightning Network, such as Exodus, Wallet of Satoshi, or Zeus (Exodus and Wallet of Satoshi discontinued service for users in the United States as of early 2024). Alternatively, users can access the Lightning Network through centralized services like Coinbase or apps like Cash App.
2. Fund your account with BTC: Transfer Bitcoin to your Lightning Network-compatible wallet or platform to fund your first payment channel. Businesses, individuals, or websites accepting Lightning Network payments often provide a QR code or link to make connecting wallets seamless.
3. Open a payment channel and start transacting: Once funded, create a payment channel by linking your wallet to another Lightning Network user’s account. You can then send payments to anyone on the network. When you're ready to withdraw your BTC back to the main blockchain, simply close your payment channel.

Are there alternatives to the crypto Lightning Network? 

There's no denying the Lightning Network is on its way to becoming the leading protocol for Bitcoin microtransactions. However, several competing technologies and payment solutions also offer options for fast, affordable cryptocurrency transactions. Here are a few:

Payment-focused altcoins

Some projects, such as Solana (SOL), Litecoin (LTC), Bitcoin Cash (BCH), and Ripple's XRP (XRP), provide quick and cost-effective peer-to-peer (P2P) payment solutions. While they don’t use Bitcoin or match the Lightning Network’s speeds, these blockchains are secure and offer reliable alternatives for crypto payments.

Stablecoins

Stablecoins like Tether (USDT) and USD Coin (USDC) maintain stable values pegged to assets like the US dollar. This volatility-free approach makes them an attractive option for transferring value across blockchains, especially when price stability is a priority.

L2 rollups

Although often associated with Ethereum (ETH), L2 rollups could enhance Bitcoin’s scalability by batching transactions offchain and periodically submitting them to the main chain. Similar to the Lightning Network, rollups provide low fees and fast speeds while also enabling integrations with decentralized finance (DeFi) applications.

Wrapped Bitcoin (wBTC)

wBTC is a tokenized version of BTC with a 1:1 peg to Bitcoin’s market price, operating within Ethereum’s ecosystem. This allows wBTC holders to access faster transaction speeds and lower fees on Ethereum while enabling passive income opportunities like liquidity pools, staking, and yield farming.

Payment card-sponsored blockchain solutions

Visa and Mastercard are exploring blockchain technology through new products like Visa Direct and Mastercard Crypto Credential. These private blockchain solutions aim to streamline global payments and expand cryptocurrency accessibility.

Crypto cards

Some exchanges, such as Coinbase and Crypto.com, offer crypto debit cards that allow users to spend cryptocurrency directly from their exchange accounts. These cards handle currency conversion seamlessly, enabling users to pay in crypto while merchants receive fiat currency.  

Track your Bitcoin transactions with CoinTracker 

Whether you’re using the Lightning Network to send BTC or holding Bitcoin long-term, CoinTracker’s real-time portfolio tracker helps you effortlessly manage your crypto activity. By linking your exchange accounts and wallets, you can view transfer details directly on your dashboard. CoinTracker also streamlines tax season by creating compliant tax reports for your CPA or software like TurboTax and H&R Block.

Get started with a free account and discover why millions trust CoinTracker for their crypto tax reporting every year. 

Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.