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Bitcoin: On-Chain & Lightning Explained

Large financial sectors work with a layering system, in which they follow a set of layers to make their transactions safe and fast. The same applies to the digital currency Bitcoin; it works on a layering system where one layer needs to be correlated with the other to speed up the Transaction and scale it up. There are many technical limitations to the blockchain; to solve them, these layers are introduced in Bitcoin.

The primary blockchain layer follows a particular set of instructions that can disrupt the speed and scalability of transactions. For this, layer two has been added to the blockchain. Let’s get to know about these layers in detail.

What is Bitcoin?

To get into details about layers of the Bitcoin blockchain, let’s get a brief on Bitcoin. Bitcoin is a cryptocurrency that is designed in the form of digital money but outside the control of any centralized system. It is one of the leading cryptocurrencies in the world, which came out to the public in 2009. The popularity of Bitcoin has inspired many other cryptocurrencies to come into existence. Now let’s get to Bitcoin’s Transaction through an on-chain and lightning network.

What is Bitcoin On-chain?

An on-chain Transaction that is verified in a blockchain by miners and validators. On-chain is the base layer of blockchain; it represents blockchain transactions. In cryptocurrency, the transactions that take place are publicly available on this ledger. This is a recorded blockchain transaction whose information will always be publicly available when completed. It is considered a safe transfer form, as six steps are involved in validating one Transaction.

How does Bitcoin On-chain Transaction work?

These transactions are on a blockchain and follow simple steps to complete payment. First, an on-chain transaction needs an address to which its Transaction must be sent. When the amount and address are mentioned, an instruction will flow to the public ledger, and those who have access to that can see the time, amount, and transaction address. On-chain transactions depend on the volume of the currency sent; if the transaction volume is less, then the time of settling down the Transaction is fast.

After the Transaction is initiated in the blockchain, it will need sufficient blocks to get it verified, which implies that network participants have to confirm the transfer and also miners need to solve the mathematical problem each time when a block is added to the blockchain; when a miner validates the Transaction, then it gets stored in the blockchain and became irreversible. The receiver gets its payment when all of these processes get completed.

The Transaction runs in a chain of networks, and when one process is completed, it moves to the other one, which is why it is “On-Chain.” During the initial stage of blockchain, the transaction volumes are less, and the on-chain transactions get settled instantly, which inspires more cryptocurrencies to be a part of the blockchain.

Benefits of On-chain transactions

On-chain is the base layer of blockchain, and it is very convenient and secure for any payment conducted through blockchain. Certain benefits make on-chain transactions so reliable on a blockchain.

  • Security: It is secure as the blockchain data is end-to-end encrypted and cannot be altered or reversed once recorded.
  • Decentralized: Blockchain does not come under any central authority and is free from any governance, making it risk-free from breaching trust or manipulating any data flow.
  • Transparency: Blockchain network uses a distributed ledger to record and validates transactions at multiple locations. All this information is stored in the blockchain, which anyone can see through bitcoin explorer.
  • Ease of use: Conducting an on-chain payment is effortless by adding the receiver’s end address, and miners and the blockchain system do all the other work.

Drawbacks of On-chain transactions

Being a reliable method of transferring data, on-chain transactions have drawbacks that make people shift from it or find alternatives to blockchain transactions.

  • Slow Transaction: The speed of a blockchain transaction depends on the volume of Transactions in the processing queue. This creates network congestion and slows down the speed of transfer.
  • High Transaction Fee: If there are high demands in the network, then it raises its network fee, so if a person’s transaction volume is high, then the web can be too expensive to use.
  • Excessive Power Usage: There is a proof of work mechanism that miners use to validate transactions; this process consumes a lot of computational power.

What is the Bitcoin Lightning Network?

A lightning network is a layer two solution; in the Bitcoin blockchain, these layer two solutions are mainly used to improve scalability in a blockchain. It is associated with Bitcoin and enhances the utility value of the chain. When Bitcoin was invented, it was thoroughly on the idea of making a peer-to-peer payment method without any intermediary. But after some time, it was clear that a second layer needed to be implemented for better scalability.

There are four features and products which are built over the lightning network; let’s get a brief about them;

  • Loop: As its name suggests, it creates a loop transaction, like a lightning transaction can be sent to an on-chain bitcoin network, similarly an on-chain transaction sent directly to the lightning channel.
  • Pool: There are liquidity needs of users in lightning networks, and the pool helps with that.
  • Taro: It helps in issuing the assets on the lightning network and minting them.
  • Faraday: It is a data analytics tool that provides help to node operators to optimize channels and the flow of funds.

The lightning network uses micropayment channels to scale blockchain capabilities to conduct all the transactions more effectively. All the transactions done through the lightning network are fast, less costly, and configured compared to the blockchain.

How does the Lightning network evolve?

In 2015, there was one major issue that the Bitcoin blockchain was facing: the hike in transaction fees. To solve this, Joseph Poon and Tadge Dryja, together called the maverick duo, started working on decreasing the cost of transactions. Later in 2016, a white paper was published, which attracted more developers to collaborate with them.

A couple of years after the white paper Lightning Labs, the company that maintains Lightning Network launched a beta version for the test purpose. This beta version attracts the eyes of the tech market, and they identify the value of layer 2 in the blockchain ecosystem.

Lightning Labs gained the trust of many big companies like Twitter as its then CEO Jack Dorsey supported them with a plan to integrate the lightning network with Twitter; in 2020, lightning labs released features like keysend and Wumbo channel. The release of Wumbo increases the transaction size over the LN.

Currently, the LN ecosystem has many verticals and functionality, including gaming, wallets, payments, node management, infrastructure, and rewards. With all these new features and the latest releases, the lightning network ecosystem is turning out to be the most advanced in the crypto world.

How does the Lightning network work?

The lightning network gets leverage from the concept of payment channels which Satoshi Nakamoto started. This concept implies the peer-to-peer payment channel between two users. Once a channel is established between them, the information related to the opening of the channel will be sent to the main blockchain.

When a channel is created, it allows both parties to send and receive unlimited amounts of transactions; these transactions are instant and non-expensive. From small to large, all payments can be made through LN without affecting the Bitcoin network. To create a payment channel, the user must lock a certain amount of Bitcoin in a network.

Once the amount of bitcoin gets locked in the network, the recipient can take the invoice amount as needed. These channels run based on the channel contracts both parties agreed on when opening the channel.

When transactions occur, all the information does not get saved in the main blockchain, as lightning networks do not need approval from all the nodes. But when a channel is open and closed, a compiled transaction gets stored in the blockchain. To keep the channel open, parties have to add bitcoins to the channel constantly.

All the routing transactions are formed by combining individual channels between the parties. Thus, a lightning network is a combination of multiple channels linked together.

We can also understand the Transaction in a lightning network through an example:

If a person named Mike goes to a coffee shop and wants to pay in Bitcoin, he needs to create a channel with the coffee shop owner; after that, the lightning network will devise a smart contract where rules are coded and can not be broken. This contract is made to ensure that all the process gets automated and payment requirements are completed without any third party. When Mike completes the payment to the coffee shop, he can close the channel, but if he wants to continue, he has to add a certain bitcoin to its account.

During the final payment and channel being closed, compiled data of the overall Transaction between Mike and the coffee shop gets stored in the blockchain mainnet. This prevents the long time data takes to process and improves the scalability of the overall Transaction.

Advantages of Lightning Network

Apart from its being a layer 2 in the Bitcoin blockchain, there are multiple benefitting factors due to which the lightning network is getting into the limelight. Let’s see some of these advantages:

  • Transaction Speed: The payments made through the lightning network get settled almost instantly, as every Transaction does not need validating nodes to get settled down.
  • No limits: There is no limit on maximum transactions on a lightning network until and unless one has required funds and a channel pathway.
  • Low transaction fee: Bitcoin transactions are generally costly, but with a lightning network, it costs very little and makes the payment convenient for the users.
  • Provides Privacy: Individual payments are not stored in the blockchain, and thus those transactions are not publicly available in the blockchain.
  • Decentralized: Lightning network users run their nodes and can maintain their payment channels. So, the involvement of any third party gets eliminated, which makes the whole system decentralized.
  • Censorship Resistant: Despite being a massive web for payments, every user creates its payment channel; with this, the benefit is that even if a user is found censored or exploited, the rest of the network remains functional, and transactions do not get affected.
  • Scalable: All the payments on LN are usually traversed through multiple payment channels. These payments are routed through four or five hops; generally, one hop takes a second to pass on, then the whole payment gets settled in a few seconds, making LN a scalable payment option.
  • Routing Nodes: The nodes that forward the payment in a lightning network get incentives in the form of routing fees, payment routing results in less expensive and more reliable payments. Routing nodes benefit from each amount they process; thus, more payments get clear in no time.
  • Micro-payment Support: Payments done in small segments do not get stuck in the processing network from small to large; all the payments get instant settlement; hence even the micropayments get support in LN.

Potential drawbacks of Lightning Network

The lightning network has solved many major issues in Bitcoin on-chain networks, but certain drawbacks can come in the future.

  • Fund Transfer Cost: A lightning network makes cost and Transaction efficient, but once a channel is created, the process of setting that up is slow and complicated; users have to transfer funds and then lock them into the lightning network; this process of moving funds can be a bit expensive.
  • Risk of counterparty during Transaction: When funds are locked in the channel, there are risks like funds being stuck due to technical issues, or the counterparty can close the channel when the user is offline and keep all the funds for themselves. Although watch towers and service providers mitigate these risks, it adds a bit of centralization to this network.
  • Difficulty in Functional Scalability: In LN, a payment channel is only between two parties, and hence if a business wants to send money to other customers, then it has to create separate channels for them, and keeping track of all the transactions is a bit difficult and sometimes increases counterparty risk.
  • Hacks and malicious attacks: There is a network congestion risk during a malicious attack. In this case, the user can’t get their money back faster; attackers usually use denial of service attacks to congest and freeze the channel.

Future Perspective of Lightning Network

A lightning network is a viable transaction tool and even better for making micropayments. When the lightning network was initiated, very few wallets supported LN and, at the same time, mobile-friendly. Statistics of LN are seen as modest with respect to other layer-2 chains.

Lightning Labs developed Lightning Network and are expanding its developer’s toolkit and user ecosystem on the network. Due to such an initiative, some applications support DeFi, liquidity, and NFTs support.

Nowadays, cryptocurrency exchanges support the LN protocol to ensure it reaches as many traders as possible. There were offline frauds before, but to counter that, LN started watchtowers that protect the funds; it detects the offline nodes, freezes the funds, and penalizes the malicious party.

The ecosystem is evolving based on robustness and improved scalability; in the future, features will enhance the user-intuitive experience and create trust networks with other exchanges to integrate them with lightning networks.

Speed

Speed is a Bitcoin payment processor where individuals and businesses can send and receive payments. It is a secure platform where you can perform your Transaction in a lightning network. Its easy-to-use interface makes it a simple-to-understand platform for beginners willing to transact in Bitcoin and stablecoin.

In the speed platform, payment can be made globally with no chargebacks quickly, easily, and securely. With speed, you can use the lightning network for all your transactions, to secure the data speed provides an encryption facility.

Conclusion

In Bitcoin, blockchain transactions are done through both on-chain and lightning networks. On-chain transactions are like sending money through an online system, which is decentralized and available to the public through a ledger. Conversely, a lightning network overcomes the drawbacks faced in on-chain transactions.

On-chain has made payments on a network, and the lightning network has improved its scalability. Both are easy ways to transact bitcoins, but the lightning network has many other advancements that provide higher security and speed in transaction settlement. A competitive market in layer 1 is for mining which offers security; similarly, routing nodes keep the payments stable and competitively priced in the lightning network.

With all the advantages and potential drawbacks, you can understand everything about Bitcoin on the chain and the lightning network in the above blog.

Speed Team

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