Let’s say that two parties know that they’re going to transact with each other frequently, so they don’t want to continually pay network fees or wait 10 minutes for a transaction to settle. Instead of broadcasting transactions on a node, a payment channel is created between the two parties (let’s call them Alice and Bob) using a multisignature address on the blockchain, which is signed by the private keys of both parties. At least one of the parties needs to deposit Bitcoin into the address. This address essentially works to put the funds in escrow, only allowing them to be unlocked once both parties agree. It operates as a balance sheet that will record future transactions.
Since the payment channel has been established, Bob can send Alice 0.01 BTC without needing to be validated by a miner on the main chain. Alice and Bob cryptographically sign each transaction, which works as a receipt against the funds in the wallet. As long as there are enough funds in the wallet, Alice and Bob can send thousands of transactions between them nearly instantly because these transactions are occurring off the main chain. Once Alice and Bob decide to close the channel, the payment history is calculated into a single transaction and settled onto the Bitcoin network.
In the example above, payment channels basically operate as nodes on the Lightning Network. Because each transaction is signed cryptographically, it’s not possible for Alice or Bob to cheat the system or steal funds. The Lightning Network also allows transactions between nodes: if Alice and Bob have a payment channel and Alice and Jason have a payment channel, then Bob and Jason can send each other lightning transactions. These transactions are a kind of unconfirmed Bitcoin transaction that is guaranteed by the funds put in escrow when the channel is opened.
Currently, the fee for a median transaction of .04 BTC is around 0.00011 BTC ($.08 today). On the Lightning Network, the median fee rate is ...