the lightning network – Forex Academy

Solving the Bitcoin scalability problem is no easy task. This problem has taken a long time of research and development, but the solution could already be among us. Its name is Lightning Network and could lead Bitcoin to the apex of scalability to deal with the massification of cryptocurrencies.

The Lightning Network protocol is a protocol designed to improve the scalability of Bitcoin. This is possible because Lightning Network works as a second layer on Bitcoin. One that allows this cryptocurrency to perform things that it normally could not and more specifically; instant transactions with very low commissions. The development and creation of this protocol began with the work of Joseph Poon and Thaddeus Dryja. But at present, it is companies such as Blockstream, Lightning Labs, and ACINQ that drive the development of it. The whitepaper of this development can be found at that link on their main website.

To understand a little of the potential of this technology, we need to keep two things in mind. The first is that Bitcoin was created as a digital money solution. Second, that goal is impossible to achieve in the current state of the Bitcoin network and software. The reason for this is very simple: Bitcoin has trouble scaling.

Currently, Bitcoin can only process 7 to 8 transactions per second. This is a very small capacity and it cannot cope with the massive use of cryptocurrency. As a result, the Bitcoin network becomes slow and very expensive when it comes to paying commissions. For this reason, a new way of performing transactions quickly was needed, which was simple to use and compatible with Bitcoin without making major modifications. The answer to these needs and more is Lightning Network, a protocol from which we will learn a little more below.

Why is needed to improve the scalability of Bitcoin?

Surely you are asking yourself this very question and it is your right. You will think that if Bitcoin has such a powerful and extensive network then why it should improve its scalability. The short answer is; because by improving scalability, transactions are done faster and less expensive.

To explain the answer at length let’s do this little exercise. Imagine you do a transaction in Bitcoin. At that time the Bitcoin network has very little use and the commission cost of each transaction is very small.

However, the cost of fees may increase as network usage increases. This is because a queue or excess of transactions is generated in the mempool. It is there that miners tend to prioritize transactions with higher commission payments for more profits. That way, if you want a transaction to be processed quickly, then you will have to pay more in commissions.

But the latter case also tells us that commission costs will increase to the point where we will not be able to make micro-payments. For example, sending 1 dollar may result in more than 1 dollar for the cost of the commission. This is a meaningless situation and one that scalability improvement can solve, hence the need to improve this feature.

How Lightning Network works

The operation of the Lightning Network depends on several technical factors and a process to make it safe to use. First, Lightning Network depends on the non-malleability of the cryptocurrency being secured. In this way, it would be impossible for a third party to change the information about the transactions or cryptocurrencies during the verification or generation process.

In Bitcoin and Litecoin the non-malleability property of the transactions was introduced thanks to the arrival of SegWit (Segregated Witness). With this soft fork, Bitcoin solved this problem and put the first building blocks for a new way to scale its capabilities.

That’s how the development of Lightning Network and its so-called pay channels began. These payment channels are the cornerstone of Lightning Network operation and the key to enabling unprecedented scalability in Bitcoin.

What are paid channels?

Payment channels are the basis of the Lightning Network. A payment channel is actually a multi-signature transaction in the blockchain with at least one of them sending funds. In this channel, each person has a private key and each future transaction can be made only if the keys of the two parties sign. This is a means of consensus that the compromise has been approved to be executed by both parties.

In addition, payment channels may be open for a certain period of time. Normally this is about 10 minutes or what it takes to mine the next block on the blockchain. But once the channel is opened, channel participants can instantly exchange assets between themselves using the funds stored in that channel. In a nutshell, this means that parties that are part of a Lightning Network payment channel can make payments to each other instantly.

Despite this behavior, the transactions made in said payment channel are completely valid in the blockchain. This is because once the channel is closed, the transactions made are transmitted to the network, verified, and included in a Bitcoin block.

Explaining how Lightning Network works

To understand how Lightning Network works, it’s best to break down your entire operating process step by step. For that reason, we will explain to you a simple exercise on how to perform this process along with other points of interest to clear all your doubts.

First, within Lightning, we will have two participants who will create an initial transaction in the $20 blockchain. Of that $20, $10 will be from Carmen and $10 from Aitor. This deal could be different and can vary within the channel we mentioned earlier, so Carmen could have $15 and Aitor $5 at the end of all exchanges.

What Lightning does is take the technology behind the paid channels and create a network that shapes them using smart contracts to make sure the network can run on a decentralized basis.

In this regard, we would have the following breakdown of the process:

Carmen opens a pay channel with Aitor that in turn has a channel with Laura, which in turn has an open channel with David.
Right now we have 4 parties participating in different payment channels or payment channels.
Carmen wants to exchange assets with David, so she can send funds through Aitor and Laura to ultimately reach David, the recipient.

Due to the nature of the Lightning Network, Carmen would not have to rely on Aitor and Laura within the process as cryptography is used to ensure that the funds David will receive will be exactly the same as Carmen has sent. Otherwise, they’ll be automatically returned to Carmen.

If you were to ask a few people what makes Bitcoin a special internet currency, you’d most certainly hear that “Bitcoin is anonymous.” That’s because that’s the song sung on social platforms and drummed in by the media constantly.

What people forget is that Bitcoin is also completely transparent. Thus, it would be ironic for it to also be anonymous.

What Bitcoin is, rather, is pseudonymous. This means it’s anonymous, but only up to a degree.

The Bitcoin website clarifies: “Bitcoin is designed to allow users to send and receive payments with an acceptable level of privacy as well as any other form of money. However, Bitcoin is not anonymous and cannot offer the same level of privacy as cash.”

So what exactly is this pseudonymity? What are the intricacies that make Bitcoin anonymous, yet not? And why should you care?

Let’s answer each of those questions.

Why Stay Anonymous?

There is a lot of talk about Bitcoin’s anonymity or lack of. Why should it matter?

First, you need to remember that Bitcoin’s reputation as “the internet’s gold” makes it an ultra-attractive target to fraudsters, hackers, and other such elements. Any weak link they can exploit to unscrupulously acquire Bitcoins, they will. Countless stories of such incidents abound.

There’s also the little matter of privacy. Some people may just want to conduct their transactions privately, for whatever reason. Remember, if your address is linked to your identity, it reveals the following information:

How many bitcoins you held/are holding in that address
When, and from whom you received them
The address to which you sent them

Obviously, this is sensitive information that you never want leaking. Staying anonymous can ensure you protect yourself and your finances.

How Do Bitcoin Transactions Work?

To get a clearer grasp of Bitcoin’s anonymity, we need to first understand how Bitcoin transactions work. The Bitcoin protocol, at its very basic level, comprises a series of transactions in the form of blocks. The transactions are packages of data, which include transaction ‘inputs and outputs.’

Inputs are the Bitcoin addresses from where bitcoins are sent, while outputs are the addresses to which bitcoins are sent. Each Bitcoin transaction transfers coins from one or several inputs to one or several outputs.

It’s also possible for a transaction to have one input and several outputs, but that rarely happens as it would mean the amount of funds to be sent (output) would be exactly the same as the amount received earlier (input).

It’s more common to find transactions that consist of multiple smaller inputs that translate into one larger transaction. For instance, if an individual controls two different inputs of 3 bitcoins each, and needs to send 3.5 bitcoins to an online store, the Bitcoin protocol will merge the two inputs into one transaction.

Even then, a transaction with multiple inputs is more common, since Bitcoin uses ‘change’ addresses. Change addresses allow users to spend the extra Bitcoins in a transaction – from one or several inputs, back to them. Consider the example of taking a $10 bill out of your wallet to pay for a $5 ice cream. You would give $5 to the cashier, and they would give $5 back to you. The $5 belongs to you, but it’s not available to you between the time you hand the bill to the cashier and the time they give it back to you.

What Makes Bitcoin “Anonymous”?

Bitcoin is widely regarded anonymous due to these reasons:

First, unlike traditional payment systems, a Bitcoin address is not tied to the transacting individual. A network user can create a new and random address anytime, as many times as they want, without submitting personally-identifying information to anyone.

Second, even transactions are not tied to the participant(s) of those transactions. Due to this, anyone can transfer bitcoins from any address whose private keys they control to any other address without having to divulge any personal information. Not even the receiver will know the identity of the sender.

Third, transaction data on the Bitcoin network is transmitted in a random fashion on the peer-to-peer network. While computers on the network connect to each other via identifiable IP addresses, it’s hard to trace exactly where data originated from, thanks to that randomness. No one can know if data originated from a particular node, or if that node merely forwarded it.

How Are Bitcoin Transactions De-Anonymized?

There are three ways through which Bitcoin’s anonymity can be undone.

First, although Bitcoin transactions are transmitted randomly over the network, it’s not a completely foolproof system. If a person has enough time and the tools to connect multiple nodes, it’s possible to determine the origin of a particular transaction.

Second, Bitcoin addresses can be linked to real identities if the addresses are used together with real identities in one way or another. Some of the ways this could happen are:

Addresses depositing/withdrawing funds from a centralized wallet or crypto exchange
Donation addresses that can be found/seen in the public domain
Using an address to send bitcoins to someone using your real identity

Thirdly, and perhaps most obviously, all transactions on the Bitcoin network are completely transparent and open for anyone to see. This transparency is the one that enables a determined person to cluster multiple addresses together and trace them to a user.

What is Clustering?

When we speak of clustering, what do we mean?

Clustering is an attempt at analyzing transactions on a network, say, Bitcoin’s. The simplest explanation is this: combining multiple inputs into a single transaction. The inputs in question may have originated from different addresses, but the fact that they could be combined into one transaction means they originated from the same user.

Change addresses could also be identified and linked to the sender of a transaction. When receiving Bitcoin, the output may not be attributed to you, but it most likely will be attributed to the sender. There’s also a type of software that reveals the owner of a change address to anyone who cares to dig. Such software may be configured in such a manner that it reveals the change address as the last output of transactions.

Taint analysis is another method used to cluster transactions. This involves calculating the percentage of bitcoins one address received from another address and whether different addresses are, in fact, controlled by one user.

Another clustering method is amount analysis and timing analysis. Amount analysis tracks how many bitcoins were sent in a particular transaction. Timing analysis tracks when a Bitcoin transaction occurred.

How to Achieve Privacy over Your Bitcoin Transactions

1. Run Your Own Full Node

Conducting a transaction on the Bitcoin network requires you to have a wallet that is connected to a Bitcoin node. Bitcoin nodes are multiple computers that validate transactions before they’re recorded on the Bitcoin blockchain. If you’re transacting on the Bitcoin transaction and not running a full node, you’re relying on someone else’s, and you don’t have full control over your transactions.

Not running your full node also has other less obvious implications. For instance, let’s say you’re using a certain wallet. You’re relying on this wallet to transmit and receive funds. Of course, the wallet service will claim not to tie your identity to the serial number of the wallet, and that they don’t collect your information when you’re setting up the wallet. Still, your IP address will be tied to the device, and your privacy and anonymity are compromised.

You can avoid all of these scenarios by running your own full node. Take control over your transactions by not letting anyone verify your transactions for you.

2. Use a VPN

An effective VPN (virtual private network) hides your IP address and encrypts your traffic so no one can see where you’re logging in from or what websites you’re visiting. Also, the sites you’re visiting will not know your IP address and your location.

Running a full node ensures you can hide your location and IP address via a VPN. This way, any interested party cannot tie you to the node.

When you’re using VPNs, you need to know not all are reliable. For instance, free VPNs will not be of much use. Other VPNs cannot be trusted to protect your data. Before you use any VPN, always conduct your own research to establish its reliability and how it has handled customer data in the past.

3. Use TOR

TOR is short for The Onion Router and is a powerful anonymity tool that can also hide your IP address. Once activated, TOR operates as a separate browser that disguises your IP address and identity by routing your connection through random nodes on the Tor network such that your traffic cannot be traced back to you. The result is that it will appear as though you were coming from an entirely different country or state. If Bitcoin transactions are routed through Tor, there’s no way for anyone to know where they’re originating from.

4. Use the Amnesic Incognito Live System (TAILS)

TAILS is a live system that enables user security and privacy. It features an interface that can mimic the appearance of Windows so that a casual observer will not notice anything unusual with what you’re doing.

You can use the TAILS system to anonymously send or receive Bitcoin, including from a public computer, without leaving a trace of your activity or identity.

5. Use the Lightning Network (LN)

As you already know, all transactions on the Bitcoin blockchain are public. If someone knows your address, they can trace transactions back to you.

Enter the lightning network. The lightning network is an off-chain layer for Bitcoin. Instead of transactions taking place on the Bitcoin blockchain, they take place on the Lightning network, offloading traffic off the Bitcoin blockchain. Like the Bitcoin network, the Lightning network also has multiple nodes. But unlike Bitcoin’s, the Lightning network’s nodes do not keep track of every transaction. The only information stored by the Lightning network is the interaction with other nodes.

Transactions in LN occur via two-way payment channels that only add the final transaction to the blockchain. Since not all transactions are added on the blockchain, LN is a great way to increase the privacy of your transactions.

Final word

Bitcoin is not anonymous. It provides a certain level of privacy, but it will not guarantee that your transactions will not be traced. With this knowledge, you can know how to stay safe while interacting with Bitcoin and how you can do so.