Basic principle

• The Blockhain will continue to function unaltered (same blocksize, PoW mining, etc.)
  
• But instead of every transaction being stored, payment channels are used, which can be regarded as direct p2p connections between nodes (users) on the network.
  

Payment channel

Inside a payment channel, the nodes that established the channel can freely exchange bitcoin as their starting balance permits. These transactions are referred to as off-chain transactions because, unlike regular transactions, they are not immediately recorded onto the blockchain. Only when such a channel is closed, will it lead to an actual final transaction, aggregating all transactions made. Off-chain transactions are secured by the nodes’ shared knowledge of a random number, generated upon establishing the channel.

On-chain transaction

The resulting transaction is handled on-chain by the network as usual. Should one of the transactions in the channel be malformed or invalid, the whole transaction – and thus all transactions made in the channel – will fail.

All nodes can freely create channels between them. So in the example, A can transact directly with B and D, but also with C through B, and E through D. There is no time-limit for channels, so these can stay open indefinitely – or until funds are to be released, upon which (one of) the nodes close(s) the channel.

Speed

The Lightning network will, in theory, be able to handle millions to billions of transactions per second (TPS). This blows away legacy systems, such as VISA, by many orders of magnitude.

Overview

Continued reading / sources

• Lightning Network – official website
  
• How MasterCard Processes 74B Transactions a Year
  
• Understanding Payment Channels
  

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