A successful payment processor must allow a user to execute fast transactions at a low fee. This is the area which cryptocurrencies are in some way flawed; some Bitcoin transactions can take hours to verify and the fees can be extremely high if a user wants the transaction verified quickly. This is impractical, especially if Bitcoin is to be used across the global economy for small transactions.
VISA is capable of processing 56,000 transactions a second and cryptocurrencies are currently not able to compete, hindering their potential for widespread adoption in the future. Whilst some cryptocurrencies are trying to update the actual blockchain, enabling it to handle more transactions, there have been other developments aimed at helping cryptocurrencies compete with larger payment processors.
One such development is what is known as the Lightning Network. The core idea behind this revolutionary technology is that it operates off-chain. It allows instant payments to take place between users without actually committing these transactions to the blockchain.
How It Works
To start, two users open up what is known as a ‘bi-directional payment channel’. This is done through each user depositing a set amount of coins into a certain address. This initial transaction is written onto the blockchain. However, these users can then do as many further transactions as they want off-chain, instantly, without any transaction fee. This is possible because they are operating within this ‘channel’ and not on the actual blockchain. After a set amount of time, the channel can then be closed- however, both parties have to sign with a digital signature to enable this. The final balances are then written to the blockchain. Whilst hundreds of transactions may have taken place, only two are actually written onto the blockchain. What is particularly notable about this idea is that it can be scaled.
If we have three users (A, B and C), users A and B can set up a payment channel, and users B and C can set up a channel. Since user B is used by both A and C, user A is able to send money to user C via B as many times as they want. B effectively acts as a middle man for payment. This payment would still be instant and could enable money to be sent across the world instantly, with little or no fee. As the Lightning Network is adopted across more countries and by more people, more channels will be opened. There will then be an entire network of these channels operating off the blockchain with instant transactions taking place. The only transactions that are written to the blockchain are the opening and closing transactions, recording the final balances.
Applications in the Real World
This makes the use of cryptocurrencies much more practical for merchants who may be selling low-cost goods. For example, someone who visits a cafe every morning before work can set up a payment channel with the cafe, allowing them to use a cryptocurrency to make an instant transaction without a fee. This channel can stay open for the entire working week, and at the end of the week, the final balances are written to the blockchain. This takes the stress off the main blockchain and will prevent the system from being overworked.
There is also no risk of being cheated. For example, if user B (the middle man) decides not pass on the money to C, user C has a secure cryptographic hash which is only revealed to B once the transaction is made. User A also has access to this hash, and can demand that B proves the money has been passed onto C. This means that anyone can use this technology safely and without the risk of their money not reaching the correct person.
The Risk to Decentralisation
One of the main selling points of cryptocurrencies, and the blockchain technology in general, is the decentralisation that it offers. Users do not have to rely on a central financial institution to manage their funds for them and people can withdraw their money whenever they want. In an ideal scenario, the lightning network would remain decentralised and everyone would be able to make channels with each other.
However, in reality, the industry will see the rise of central ‘hubs’ through which most payments will pass. The systems of transactions can be divided into two: a ‘centralised’ system and a ‘decentralised’ with centralised hubs. The latter is what the Lightning Network will aim for.
Therefore, whilst it could be argued that this takes away one of the fundamental selling points of cryptocurrencies, it is a small price to pay to enable widespread use of the currencies which is not possible in the current state. Furthermore, the actual blockchain is still a decentralised system at its core.
Bitcoin, Litecoin, or Both?
The Lightning Network has not been enabled on the Bitcoin blockchain yet, but it is capable to host it in the near future. Another popular cryptocurrency, Litecoin, is pioneering the initial use of the Lightning Network. The first Lightning Network transaction was executed using Litecoin by the developers, proving that the technology does work and that it is almost ready to be fully rolled out onto the system.
However, the technology is even more revolutionary than described above. What if one user owns Bitcoin, but the merchant they are buying from charges in Litecoin?
This is where ‘atomic swaps’ come in. Atomic swaps use the Lightning Network to form a bridge between different currencies, by forming channels across blockchains. The middle man and payment processor can have both Bitcoin and Litecoin channels open. Using the same technology described above, the buyer can pay their Bitcoin to the middleman, who then does the exchange and returns Litecoin to the seller, using a separate channel on a separate blockchain. This is all still taking place off-chain and with no transaction fee, as it uses the Lightning Network.
Atomic swaps are fundamental as they will facilitate the use of any cryptocurrency on the Lightning Network as the user does not have to own the currency they are paying in. There are no trust issues as the users are cryptographically committed to fulfilling the payments. This is effectively a decentralised exchange service operating within the Lightning Network, taking the stress off the actual Blockchain.
The creator of Litecoin, Charlie Lee, has a vision of Litecoin and Bitcoin working together in the future by using these technologies. Through the Lightning Network, payments will be secure, instant and across cryptocurrencies. Once this is enabled on both the Litecoin and Bitcoin blockchains, it will be a huge step towards cryptocurrencies becoming commonplace in the world economy.