There has been a lot said of what Lightning Network is similar to. Some of the analogies are wrong, some of them are partly right. I’ll try to break down a few of them here, and where they fail.
Lightning Network is IOUs
This is partly right. But what is an IOU? It’s a paper of guarantee, that you will have to trust that someone redeems for *real* stuff. In Lightning, the degree of trust you need is extremely limited, and if the other party refuses to redeem it, you’ll take it to the ultimate arbiatrator – the blockchain. You can also at any time update the amount of money you have in the IOU, and in fact you are holding the same kind of IOU for your partner. I don’t think this analogy is very good. IOUs are bad because you have to trust that someone upholds their word. In Lightning Network, this is all cryptographically secured in a smart contract on the blockchain.
Lightning Network is banks
This can also work partly, but it fails the same way as the IOU analogy. You have the blockchain as the ultimate governor, you don’t need the banks approval to withdraw. There’s also no way that a Lightning Node can know from where or to where a transaction is going. It’s just routing.
Lightning Network is a prepaid credit card
This is perhaps the best analogy so far, but the analogy has its limitations. Actually, main limitations is the same as the two previous analogies. But it is good because if you have money in a prepaid credit card, you can spend them more places than if you have cash. It’s difficult to send cash over Internet
There are some risk elements in Lightning Network. The first one is that someone – preferably you, but you can safely outsource it – has to watch the blockchain to make sure that an old channel state is not sent, giving you less money than are yours. The good thing is that if you do in fact watch for it, anyone doing that is essentially giving you all their money in the channel – it’s built into the smart contract.
The second one is that the protocol is more complex and less tested than the blockchain itself. There may still be bugs. This is of course a risk that will be smaller over time, and there is already a lot of people trusting it enough to put real money into it.
The ulimate way that all these analogies fail is that any party in Lightning Network at all times have the full knowledge how to settle to the blockchain.
Any transaction will either fail or go through. Now, there is sort of an escrow mechanism built in, so the worst thing you can risk is that the funds have to wait for a while until you can spend them somewhere else. Noone can claim any money from you unless they have a cryptographically guaranteed proof that they have paid the destination.
But wait? Will they have to pay the destination before they get the money from you? Yes and no. They have enough knowledge to claim the money, but if you do not cooperate to release the money, they’ll have to settle at the blockchain before the escrow times out.
Malicious parties can create more channel closing than necessary – but bad behavior will be punished financially.