Off-chain payment channels and settlement
The Lightning Network solves Bitcoin's throughput limit by moving transactions off-chain. Two users open a payment channel by locking Bitcoin on-chain in a 2-of-2 multisig address. They then transact unlimited times off-chain by updating balances (who owes whom), all signed cryptographically but never broadcast to the blockchain. When they want to close the channel, the final settlement is posted on-chain in a single transaction.
The network topology forms a mesh: if Alice wants to pay Carol but has no direct channel, the transaction routes through Bob (Alice pays Bob, Bob pays Carol), with fees collected at each hop. This is possible because all balances are cryptographically locked; no intermediary can steal or abort the transaction. The final settlement is guaranteed by penalty clauses: if a node tries to broadcast an old channel state (to reverse a transaction), the other party can claim the entire channel balance as a penalty.
Scalability and trade-offs
Lightning can theoretically handle millions of transactions per second, limited only by the number and depth of channels. However, it requires users to lock capital in channels (capital is less efficient than traditional banking) and adds complexity: users must monitor channels, manage watchtowers to catch cheating, and handle liquidity rebalancing. Large merchants need liquidity in both directions to serve both payers and receivers. These constraints mean Lightning works best for high-frequency, lower-value payments (tipping, remittances) rather than replacing all on-chain transactions.