How does Lightning Network add a privacy layer to the Bitcoin network?

Bitcoin is not truly anonymous at the moment. Monitoring of unencrypted p2p networks and analysis of public blockchains, combined with KYC policies and AML regulations, can reveal a lot about who is using Bitcoin and for what.

From a privacy perspective, this is not a good thing. For example, Bitcoin users may not want others to know where they spend money, what they earn or how much they earn; similarly, companies do not want to leak their transaction information to competitors.

Indeed, the traceability of Bitcoin transaction history threatens the fungibility of all Bitcoins. ‘Tainted’ Bitcoins could be worth less than other Bitcoins, potentially jeopardizing Bitcoin’s value proposition as a currency.

However, this problem can be improved. Perhaps one of the most promising solutions is the Lightning Network. Using the 'Sphinx' protocol, Lightning Network payments will be routed over a Tor-like anonymity network, providing privacy and protecting fungibility.

A brief recap of payment channels and the Lightning Network

The Lightning Network is essentially made up of bidirectional payment channels, creating a peer-to-peer network.

Bidirectional payment channels themselves can improve privacy. For example, users Alice and Bob can open a bidirectional payment channel and use it to conduct transactions through a private medium. Only when the transaction is completed, the final state of the channel is broadcast to the blockchain. The broadcasted transaction information includes the total transaction volume between Alice and Bob, but the number of transactions between them is not announced. This ambiguity helps protect privacy.

Unfortunately, there is a downside when these bidirectional payment channels are interconnected to create a peer-to-peer network. If Alice were to pay a third user, Carol, in bitcoins routed through Bob, then Bob would know that Alice paid Carol and how much she paid. While Alice and Carol still have relative privacy from the rest of the world, this privacy does not exist for Bob. If there are other or more intermediaries—not only Bob but Dan, and so on—then both Bob and Dan would know about the transaction between Alice and Carol.

Sphinx

The current Lightning Network includes a Sphinx-based solution for masking all routing data from intermediaries.

Sphinx is a protocol designed by academic researchers George Danezis and Ian Goldberg for relaying anonymous information on a peer-to-peer network. The solution was first proposed in May 2009 and initially had nothing to do with the Lightning Network or even Bitcoin. Olaoluwa Osuntokun of Lightning Labs realized that Sphinx could be exploited, and he worked with Christian Decker of Blockstream to modify the protocol to better fit the Lightning Network.

Sphinx has many similarities with Tor (The Onion Routing), a well-known anonymous communication tool. Like Tor, all packets sent using Sphinx can be encrypted - including the receiving IP address. This encryption is then performed several times until multiple 'encryption layers' are produced (hence the 'onion' metaphor for Tor).

Using clever cryptographic tricks, all of the layers of encryption are applied so that each intermediary along the route toward the final destination of the encrypted packet only opens one 'encryption layer'. This layer tells the intermediary where to redirect the encrypted packet. (Compared to Tor, Sphinx uses an improved encryption algorithm and creates a fixed-size packet to better obfuscate the location of nodes along the route.)

On the Lightning Network, the payer determines a path on this p2p network and packages a payment package on the encryption layer. In addition to passing information, each intermediary will take out some additional data, including the amount, handling fee, etc., and allow all intermediaries to set up a step in the payment chain. (In future versions of the Lightning Network, this may be extended through a protocol called 'Hornet' to further simplify the whole process - however, the Lightning Network does not urgently need this function at present.)

Importantly, all intermediaries only know which channel they receive bitcoins from and which channel they use to make payments. Intermediaries do not know whether they are the first step, the middle step, the last step, or perhaps the first step to complete the payment in the entire payment chain. Only the sender and receiver of the transaction know who sent the transaction and who received the transaction.

The advantage of bidirectional payment channels becomes apparent when these channels close — almost instantly, like on steroids. While everyone on the Bitcoin network knows how many bitcoins Alice sent to Bob while the Lightning Network channel was open, it’s not clear whether those bitcoins were sent 10 times, 100 times, or 1,000 times. What’s more, Alice may not even have sent any bitcoins to Bob: perhaps the payment from Alice to Bob was actually routed to Carol, or anyone else on the network.