Lightning Network is the combination of a routing protocol and a settlement protocol. It is a very clever interplay of some blockchain-based cryptomagic (2-2 multisig, timelocks, not-broadcasted transactions) and fintech design (deposits, borrowing, lending, automatic penalties, …). Both the routing protocols and the fintech design are remarkably similar to Ripple, Interledger and even the classic Swift.
My sketch below shows an example Lightning Network.
Alice has set up a retail account with Bob. Carol has set up a retail account with Ben. Bob, Ben and Bubba have mutual wholesale relationships. All of these lines are symmetrical from a protocol perspective, but asymmetrical from a business perspective. That is, Bob and Ben may have many thousands of retail customers, whereas Alice or Carol may have just a few accounts with parties like Ben, Bob or Bubba. The topology of the Lightning network is often called a “hubs-and-spokes” network, where the hubs are assumed to be sufficiently wealthy.
Technically, each account corresponds to a mutual deposit of bitcoins into a specially designed 2-2 multisig, but I won’t bother you with the cryptomagical details. The mutual deposits are small in case of a retail relationship and big in case of wholesale relationships. The construction is very similar to banks, that have large mutual deposits as well as huge deposits with central banks.
When Alice wants to send some bitcoins to Carol, then the Lightning Network routing protocol finds the most efficient route from Alice to Carol. In this case, that is via Bob and Ben. Next, Ben pays Carol the bitcoins, which now Bob owes to Ben. Then Bob pays Ben the owed bitcoins, which now Alices owes to Bob. Finally Alice pays Bob and the settlement is finished.
All of the transactions happen inside the Lightning Network, but outside the bitcoin blockchain in the form of signed and privately exchanged signed blockchain transactions and more cryptomagic. At any time, Alice, Bob, Ben, Bubba or Carol can close accounts/relationships. If there are no open transactions, then the closing is just done by broadcasting a final transaction to the blockchain network, updating and clearing the state of mutual deposits.
However, if a cheater closes an account or relationship mid-transaction, then the cryptomagic punishes the cheater by giving the full deposit to the other party. In such case, the Lightning Network automatically rolls back the transaction. As everyone gets (at least) eventually (because of the time locks) its money back and only the cheater gets punished, this is a strong incentive against cheating. Another way to look at these payment channels is that the underlying blockchain network is used as a fallback in case one of the parties misbehaves.
So what are the incentives of Bob, Ben and Bubba to lock their bitcoins up in the Lightning Network? Very simple: network value and transaction fees. Bob, Ben and Bubba are bitcoin millionaires and their bitcoin fortune is doing nothing other than gaining value from bitcoin deflation. By locking up their bitcoins in the Lightning Network, they add value to the Bitcoin network as it will simplify and improve bitcoin transactions to end users. So they would firstly gain indirectly. More direct gains would be transactions fees. The latter could be considered their “interest percentage” on the bitcoin-hours that they deposit into the Lightning Network.
Lightning Network is presumed to be going to work across blockchains (e.g. Bitcoin – Ether), which would make it a direct competitor to the Interledger network. The latter may be technically more mature, but it has the disadvantage that it relies on trusted third parties (e.g. Ripple “issuing gateways”) to hold the end-user deposits.
The jury is still out whether the Lightning Network would be technically and economically viable. Here are some of the many unanswered questions.
As for the last question, if the fast transaction speed of the Lightning Network proves to be its main value (seconds instead of hours), then one could speculate that some users may be willing to pay transaction fees even exceeding the regular bitcoin transactions fees …