Introduction to Channel Splicing on Bitcoin’s Lightning Network

Native Bitcoin’s Scaling Problem

As of today, Bitcoin is difficult to scale in its native form without making trade-offs related to security or decentralization due to the addition of new blocks being limited in size and frequency. This report explores improvements to the Lightning Network, a Layer 2 scaling solution built on the Bitcoin network, that help address this challenge by offering previously unattainable gains in speed, scalability, and efficiency. For readers less familiar with the Bitcoin network’s scalability problem, it may be helpful to start with our previous report, "Building on Bitcoin," for a brief synopsis.

Transactions on the Lightning Network, also referred to as “LN” or “Lightning,” work by creating a payment channel between two parties where only the first and last transactions are added to the Bitcoin blockchain, allowing for near-instant, low-cost transfers. 

On the Lightning Network, any number of transactions between the first and last occur off-chain, meaning those transactions are not limited by base layer capacity constraints. This system works similarly to opening a tab at a restaurant. Rather than being charged for each individual order, a patron, or user, is only charged once for all the associated transactions that have been batched together. This system significantly reduces fees for the users, enabling more seamless and cost-efficient transactions by freeing up block space. While largely beneficial, this is not a perfect solution. If one party were to add or withdraw funds from an existing channel, they would need to close their channel and open a new one, leading to costly inefficiencies.

The Lightning Network: An Overview

The Lightning Network was proposed in a 2016 white paper by Thaddeus Dryja and Joseph Poon to address the scalability issues facing Bitcoin.¹  Given that block space is limited, users must decide whether they would rather wait longer to have their transactions included or pay a premium to have their transactions included sooner. The Lightning Network is designed to mitigate these problems by allowing off-chain transactions to settle quickly and inexpensively.

A Lightning channel is established when participating parties create a two-of-two, multisignature Bitcoin address and fund it with bitcoin.² Once the channel is funded, the parties can transact with each other by exchanging bitcoin through their channel. To send a payment, one party creates an off-chain transaction that sends a specified amount of bitcoin in the channel to the other party. This exchange happens very quickly, enabling the payment to be settled in seconds.³

Lightning transactions are not immediately recorded on the blockchain and are aptly called “off-chain transactions.” Instead, these transactions are tracked privately by the Lightning protocol using the network of connected Lightning nodes.⁴ As the parties transact with each other, their respective balances in the payment channel change. Either party can close the channel by agreeing to a closing transaction with their channel counterparty. When one or both parties decide to close the channel, a closing transaction is sent back to the base layer with the final balances for each party.  

One notable disadvantage of this framework is that the funding transaction of the Lightning Network channel specifies its total capacity. Once set up, this maximum amount cannot be changed, making it costly and challenging to update the size of these channels.⁵

Lightning Channel Capacity Constraints Lead to Costly Inefficiencies

Although the application of the Lightning Network has helped to address some of the scalability challenges of the Bitcoin network, it is not a perfect solution. Channel capacity constraints lead to costly inefficiencies by pressuring users into constantly opening and closing Lightning Network channels when they want to adjust their channel capacity. If one party wanted to add funds to a channel, they would need to close the current channel and open a new one, requiring on-chain transactions that are inefficient and costly due to Bitcoin’s relatively slow block production and limited block space. 

The chart below displays Bitcoin transaction fees over time and shows historical spikes during periods of high network activity coupled with limited block space, leading to competition for inclusion in the available space. If user time preference is low, then fees can remain low, as participants are willing to wait to have their transactions confirmed in blocks. However, when both preference and transaction volumes are high, the total fees respond by growing in the short term. As the high fee transactions decrease, the total fee slowly falls—even if transaction volumes remain high. 

This relationship is further emphasized through the chart below, referencing the mempool by relative fee versus transaction count for this year. The mempool, effectively a waiting room for bitcoin transactions to be included in a future block, can be an indicator of network congestion and demand for block space. A large mempool indicates increased demand for block space, which may result in longer transaction confirmation times and higher transaction fees. A higher number of mempool transactions coupled with higher fees indicates that users have a higher time preference and are willing to pay a premium to have their transactions prioritized.

This contributes to challenges for on-chain transactions; users must either wait longer to have their transactions included or pay higher fees. These fees would have to be incurred by Lightning participants each time they wanted to add or remove funds from an existing channel, because they would have to either fund new channels or close their existing channels with on-chain transactions.  

How Can This Be Improved?

On a relative basis, on-chain settlement is expensive. However, if Lightning Network balances could be integrated with on-chain bitcoin as one unified balance, then transaction fees would be substantially lower. Because the fee market of Bitcoin is highly reactive to the time preference of users who have their transactions included in blocks, it is reasonable to expect that fees and on-chain settlement costs will continue to rise over time as Bitcoin adoption increases. Although the Lightning Network incrementally improves the settlement efficiency from on-chain bitcoin, its current inefficiencies and poor user experience have prevented it from being a reliable, low-fee option at scale.

If the Lightning Network is to ever develop into a foundation for bitcoin to be used as a medium of exchange in addition to a store of value, particularly for merchants, then it needs to drastically improve its user experience. In the long term, this would require moving away from an environment in which users are challenged with opening and closing Lightning channels to meet their liquidity requirements. 

These inefficiencies can be improved by allowing users to resize existing channels. This can be achieved by creating a new funding transaction that updates the capacity of the channel, in which the transaction would be signed by both parties and broadcast to the Bitcoin blockchain. Once the new funding transaction is confirmed, the channel capacity would be updated, and the parties could continue to use the channel. If merchants or Lightning users could resize their channels without having to incur extraneous on-chain costs, then the prospects for the viability of using bitcoin as a medium of exchange would drastically improve.

Splicing: The Ability to Resize Channels

Channel splicing is a technique that allows participants in a Lightning payment channel to adjust the channel capacity. To splice a Lightning channel, the two parties create a new channel with the desired capacity. They then sign a new commitment transaction for the old channel that spends the funds from the old channel in the new one. This new commitment transaction is broadcast to the blockchain, opening the spliced channel.⁶

To add to or remove capacity from a channel via splicing, an on-chain transaction is still required. However, this effectively halves the number of on-chain transactions necessary when compared with the capabilities without splicing. Before splicing, a user would have to close a channel and open a new one in two separate on-chain transactions. With splicing, there is just one on-chain transaction required when resizing the Lightning channel.  

What Is the Purpose of Splicing?

A driving purpose behind Lightning Network channel splicing is to integrate fungibility between on-chain bitcoin and Lightning bitcoin. Splicing makes it possible to build applications that have a unified Lightning Network and on-chain balance. Known as “one balance wallets,” these apps show users one total balance as opposed to fragmented on-chain and Lightning balances. Payments are handled by the application software that indicates when to use Lightning or on-chain bitcoin, making for a more seamless user experience. In theory, this should help lower barriers to entry rooted in technical complexity or understanding.

Splicing directly affects the capacity of Lightning Network channels, allowing users to increase or decrease the capacity of their existing Lightning payment channels by either adding or withdrawing funds. While this will not remove all transaction fees, because an on-chain transaction is still needed to splice, this will reduce the need to close and reopen channels through multiple on-chain transactions, decreasing the total fees for users.

Improved User Experience

Splicing also improves the Lightning Network user experience by reducing the frictions and inefficiencies associated with closing and reopening channels to adjust for liquidity demands. This can be useful for users who need to adjust their channel capacity quickly or want to reduce the Bitcoin transaction fees they are paying.

This can improve the network’s ability to route payments more efficiently and cost-effectively by making it easier for participants to balance their existing channels. This is especially profound at the provider level because wallet providers and Lightning Service Providers (LSPs) must constantly open and manage existing channels. Currently, this task is complex and cumbersome; providers must ensure there is enough liquidity available to route payments across channels on users’ behalf. Users may choose to outsource channel management to LSPs for convenience, reliability, and security. However, should demand rise unexpectedly, these providers must maintain adequate liquidity reserves of unused funds to deploy.

Splicing removes the need for the expensive opening and closing of new channels and takes away the need for LSPs or other providers to require reserve funds, constituting effectively idle liquidity that is only used when needed. This reduces the negative effects presented by operating costs, complexity, and stagnant capital challenges that providers face, and splicing addresses these challenges by enabling the direct transfer of funds between Lightning accounts at the lowest cost possible. This is advantageous for both the providers and end users; providers’ more efficient operations translate to a greater likelihood that benefits will get passed on to users in the form of cheaper fees and more reliable payments.

Why This Matters for Bitcoin Adoption

Splicing is an important development because it enables easier onboarding for new users and supports an improved Bitcoin user experience overall. This integration has the potential to lower the barrier to entry for new users because they could theoretically use their on-chain bitcoin and Lightning bitcoin as one unified payment system.

Additionally, splicing is substantially more useful for merchants who want to accept bitcoin transactions. In this situation, merchants would benefit from a cheaper fee environment given that Lightning Network channels will not have to constantly be opened, closed, and settled on the base layer. Furthermore, a more favorable fee market could create additional incentives for merchants to accept bitcoin as payment for products and services. For example, a merchant running its own Lightning Network node may receive a large amount of volume to that channel, requiring an increase of its channel capacity to meet demand. This merchant could use channel splicing to add more funds to its existing channels without having to close them entirely and be subject to the fees and inefficiencies associated with doing so.

Another byproduct of the implementation of splicing to the Bitcoin ecosystem is the potential price appreciation of bitcoin. An improved user experience could lead to more overall usage as a payment mechanism for both individuals and merchants alike, which could in turn lead to higher sentiment and adoption overall because both the asset and network benefit from more mainstream acceptance. This could create a flywheel effect, where higher adoption and usage as a payment mechanism further support Bitcoin’s use case and value proposition, potentially leading to a more attractive investment opportunity for its upside potential.

There have also been increasing Lightning Network usage and endorsements from bigger digital asset industry participants. This adoption and endorsement may create another potential catalyst to bring new users to the Lightning Network, furthering organic usage of the Layer 2 network with the bonus that major players in the industry provide infrastructure and endorse the scaling solution to bring services to ecosystem participants.

While still largely experimental at this point, Blockstream introduced the splicing feature as an option in its latest release of its Core Lightning implementation.⁷ Bitcoin technology company ACINQ also introduced the feature in its Eclair Lightning implementation, and ACINQ’s Lightning wallet Phoenix integrated splicing in July of 2023, allowing users to experience a 60% decrease in transaction fees.⁸ Will these developments lead a charge for other providers to follow suit? If so, an inverse relationship may begin to form between the number of open Lightning channels and their respective capacities.

Conclusion

The ability to resize Lightning channels should enable advantages at the provider level and create efficiencies and cost savings that may then be passed on to users. Looking ahead, splicing could be a critical development for both the short- and long-term viability of the Lightning Network and its ability to narrow the gaps between on- and off-chain bitcoin payments. 

Whether splicing is mass adopted by the Lightning Network and spurs adoption of bitcoin as a medium of exchange remains to be seen and largely depends on the demands of its users. While the proposed benefits are desirable, risks remain. Attack vectors native to Lightning leave the potential for backdoor vulnerabilities that could allow sophisticated attackers to steal funds, rendering any efficiencies created useless.

Unified on-chain bitcoin and Lightning Network balances would form an ideal stride toward improving the Bitcoin scalability problem. This synergy would allow users to access Bitcoin wallets that inherit the security of the base layer while integrating the speed, efficiency, and cost effectiveness of the Lightning Network. These enhancements underpin the development of the Lightning Network and strides toward improved efficiency, reduced fees, and simplified user experiences, creating an opportunity for the gap between Lightning and on-chain bitcoin balances to narrow. This should serve as a catalyst to propel the Bitcoin ecosystem closer to a state of smooth and user-friendly transactions.

Overall, it is encouraging to see developers in the Bitcoin community working toward solutions that seek to address the ever-persisting challenges of Bitcoin scalability. However, there is little evidence of mass demand and adoption of Bitcoin as a payment system from merchants that would benefit most from these proposed benefits. Given this, it is likely that bitcoin will remain best suited as a pristine store of value assets that prioritizes security and decentralization over scalability for the foreseeable future.

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