Scaling Bitcoin via the Lightning Network – What Must be Considered by Crypto Businesses?

The Lightning Network promises to solve one of Bitcoin´s biggest problems: The Scalability. Due to its decentralized operation mode, the Bitcoin network itself can process and settle between seven and twelve transactions per second. In part this is due to the relatively small block size of just one Megabyte per block in comparison to other cryptocurrencies and in part to the fact that all transactions must be validated by the miners and then bundled in blocks be implemented into the current version of the Bitcoin blockchain. The Lightning Network, which is already active since 2018 tries to solve this problem with an off-chain solution.

The Lightning Network is a very complicated construct from a technical point of view, which can hardly be described in a few sentences. It is a so-called Second-Layer protocol that even though it uses the Bitcoin networks infrastructure, it accumulates and resolves a certain number of Bitcoin transactions combined outside of the Bitcoin blockchain and will afterwards introduce them as just a single transaction into the Bitcoin blockchain. The core components of the Lightning Network are the so-called Payment Channels, which can be opened up between two users of the Bitcoin network. Payment Channels represent a current account relationship between two participants of the Bitcoin blockchain that opened them up, which are not managed on the Bitcoin blockchain but off-chain. If the two participants later decide to close the payment channel, their current account balance will be implemented as a single transaction in the Bitcoin blockchain. In addition, the Lightning Network enables its participants to also use already existing Payment Channels of other participants for their transactions so that transactions between participants not having a direct Payment Channel link can be processed indirectly through the Payment Channels of other participants. The usage of the Lightning Network relieves the Bitcoin network extremely with regards to the data amount to be processed as well as with regards to the computing power that miners have to spend for validation of transactions. Instead of validating each and every transaction on the Bitcoin blockchain separately, miners only have to validate a single transaction at the point in time in which the Payment Chanel is closed.

The most important effect of the utilization of the Lightning Network is the scaling of Bitcoin. The network is able to considerably increase the comparably low number of Bitcoin transactions per second. Transactions are also immediately valid without the necessity to wait for confirmation by the miners. Bitcoins appropriateness as an alternative means of payment is thereby substantially increased. In addition to this, the utilization of the Lightning network fosters financial privacy of the transaction parties on the Bitcoin network. While “traditional” Bitcoin transactions are directly and publicly included in the blockchain for everyone to see, transactions that are processed via the Lightning Network are not as such included in the Bitcoin blockchain but rather effectuated off-chain. Therefore, the amount, the involved parties as well as the origin of the transferred Bitcoins of an individual transaction processed via the Lightning network cannot be detected via the blockchain.

There is an increased demand for fast and cheap transactions, especially when it comes to the commercial handling of Bitcoins. Crypto exchanges and other service providers that handle a high quantity of Bitcoin transactions have a special interest in solutions like the Lightning Network. Crypto businesses that are obligated to observe AML obligations according to the applicable AML regulations have the problem that their auditing possibilities are substantially limited when using off-chain solutions such as the Lightning Network. They will not be able to determine the involved parties nor the transaction amount of an individual transaction. It is also virtually impossible to track the address, from which the transferred Bitcoin originate. Supervisory authorities will therefore probably be very critical with regard to the usage of the Lightning Network by supervised entities.

Attorney Lutz Auffenberg, LL.M. (London)

 I.  https://fin-law.de

E. info@fin-law.de

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