What are payment channels? (eg. the Lightning Network)

– Let’s talk about payment channels.  So if you’ve been keeping up with the Bitcoin  news cycle you would’ve heard about something  called BIP 91 locking in and that being kind of  the savior in terms of Bitcoin scaling.  You can think of this event as really  just the Bitcoin network coming together and agreeing  that Segregated Witness is gonna be something  that gets activated on the Bitcoin network.

And I high recommend you go and check out  my other video about Bitcoin scaling which kind of explains  how Segregated Witness will help Bitcoin  scale into the future by reducing the size of transactions.  But another thing that people are kind of banking on  when they talk about SegWit enabling scale for Bitcoin  is something called payment channels.  Specifically in Bitcoin world, something  called the Lightning Network.

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Now I wanna clarify that the Lightning Network  is simply a specification for a certain type  of payment channel that will exist on Bitcoin,  but there’s also other types of payment channels.  There’s something called the Raiden Network,  which would bring similar functionality to Ethereum.  The Lightning Network itself and payment channels  were actually possible without SegWit,  but without it they were less than ideal.  The reason for that is something called  transaction malleability.  In a nutshell, transaction malleability  means that somebody broadcasting a transaction  that you signed could potentially tamper  with the contents of that transaction.

SegWit allows you to put those malleable pieces  of the transaction into something called the witness  and then segregate it, so there’s no way  that a malicious node or miner could in any way  change the contents of that transaction.  So understanding that SegWit essentially enables  usable payment channels, I wanted to spend today  kind of going through what a payment channel is,  how it works, how it relates to Bitcoin,  and what it might mean for the future.  Before we dive into payment channels  and Lightning specifically, we need to talk  about how transactions are signed  and then broadcast across the Bitcoin network today.

I’ve explained this briefly in a previous video  which I’ll link below, but the crux of it is  that I have my public and my private key.  There private key being the thing that I’m able to use  to unlock those funds.  So when Alice wants to send Bob one Bitcoin,  she’s building a transaction that takes inputs  that are in her previous wallet  and says send them to Bob.  She builds this transactions and then she signs it  with her private key, basically authorizing that transaction  to be valid and people can verify  that anywhere in the future.  But at that point, Alice has just created  and signed that transaction, the rest of the network  has no idea about it.  And the rest of the network won’t know about it  until she broadcasts it out to her peers  and then it eventually gets mined and put into a block.

So basically offline, people are creating and signing  these transactions all the time and it’s not  until they broadcast them to the peer to peer network  and then a miner eventually picks them up,  which the network in aware of them  and they get written into that immutable block chain.  And this fundamental work flow is really important  to understand in the context of the Lightning Network  because the Lightning Network and payment channels  are really just Bitcoin.  They’re just those transactions,  except you never broadcast them.  You just share them with another peer.  So let’s break that down a little bit.

The magic that actually makes payment channels  kind of possible is something called multisig transactions  and many of you are probably familiar with these,  but rather than me just signing a transaction  and that’s the only authorization that is needed,  multisig transaction can require multiple people  having to sign something before it can  be authorized and then validated by the network  and there’s all sorts of cool combinations  you can do here.

You can say that we want two out of three people  or three out of four or four out of seven people  having to sign, and this actually lets you create  these mini kind of contracts within Bitcoin today.  But for Lightning and payment channels,  we’re just gonna use what’s called the two of two multisig.  And it’s really simple.  It basically requires that both parties  in this relationship sign with their private keys  before money can be moved out of an address.  And so let’s talk about how Alice and Bob would go ahead  and create a bidirectional payment channel using multisig.  So Alice and Bob know that they need to transact  regularly between one another.

The example

So they create a multisig address  and they both put in 0.5 of a Bitcoin.  So Alice sends 0.5 of a Bitcoin in  and Bob sends 0.5 of a Bitcoin in.  That payment channel is now worth, in tota, one Bitcoin.  And to do anything with the funds that are stored  in that payment channel,  both Alice and Bob both have to sign  with their private keys to move things around.  And so in the world in payment channels,  these two parties coming together to send money  into this multisig address is called opening  a payment channel.  And these amounts that they put in are called commitments,  and at this point, all of this activity is actually  taking place on-chain, so it’s happening on the Bitcoin  network, we’re actually sending this transactions  and incurring the transaction fees that go along with them.

And that’s essentially all a payment channel is,  is two parties coming together  and committing a certain amount,  and they can then transact with one another  but they both have to sign in order to change the state  of that payment channel.  So another thing that’s important to know  is that the only time you actually ever have to do  on-chain transactions is when you’re opening the channel,  i.e., both Alice and Bob putting in that 0.5 Bitcoin  and when you close it, so that the two parties  can then redeem the bitcoin out of that channel.

And this is the core concept behind  why a Lightning Network is said to be  the scaling solution for Bitcoin,  because only those two times, the opening  and the closing of the channel,  are the times you’re actually having to interact  with the Bitcoin network.  And so the opening and the closing of the channel  are the only two times you actually have to pay  the transaction fees which go to the miners  who are gonna pick up that transaction  and write it into the block chain.  And this is where things start to get really, really cool.  Once Alice and Bob both have that 0.5 Bitcoin  and 0.5 Bitcoin in there, adding up to  a total of one Bitcoin for the whole payment channel,  they can go ahead and create and sign multiple  transactions about the ownership of that one Bitcoin  between the two of them.  So for example, Bob might say,  “I’m actually gonna give you 0.2 of the 0.5 that I had.”

So now the payment channel is still worth one Bitcoin,  but Alice has 0.7 Bitcoin and Bob only has 0.3.  They can create and sign these transactions  but instead of broadcasting them to the network,  they just share them with one another.  And because of the cryptopography used  in that multisig agreement that they had,  in order to sign and verify a transaction  so that it would ever be valid back on the actual network,  both of them have to sign with their private keys.

So over the space of months, they could actually  create transactions as long as they’re both  signing them every time.  And they can create 10s, 20, 30 transactions,  but just share them with one another  and as they’re both signing with their private keys  and this multisig agreement, it invalidates  the old state of the channel and makes it so  the current state is true.  So if they were to broadcast the last transaction  back to the network in some way,  that payment channel would be closed.  And whatever balance they’d agreed on over the space  of that month, that then gets written back  into the block chain as the new distribution  of that one Bitcoin between the two parties.

But whereas Alice and Bob both locked in 0.5 Bitcoin,  0.5 Bitcoin, to a total of one,  the balances might have changed so that when  the payment channel is closed, Alice has 0.7  and Bob has 0.3.  And so you can see where the scale starts to come in here.  Because those transactions between those two parties  are essentially happening privately,  you never have to pay the fee or wait for confirmations  of any of that stuff that happens  when you’re trying to put it into the Bitcoin block chain.  There are essentially no fees and there’s  also no block size to worry about.

The throughput is just limited by your ability  to have a peer to peer relationship  with that other person you’re working with.  Alice and Bob just need to have a way of communicating  with one another in realtime.  And another cool thing is that if Alice and Bob  started as friends and then were transacting  for a while, but eventually got to a point  where they had a falling out and they’re  no longer on good terms, it doesn’t really matter,  because every time they updated the state of that channel,  i.e., the distribution that one Bitcoin,  they both signed it with their private keys  in that multisig agreement.

If Alice no longer wants to do business with Bob  and wants to close the payment channel, she can  simply broadcast the last transaction that  they both agreed on back to the Bitcoin network  and redeem her Bitcoin.  It’s not locked away and there’s no way  that Bob can run off with the money.  And I think it’s really important to understand  this core concept because the Lightning Network  is just Bitcoin.  The only difference is that parties that have a relationship  with one another don’t always need to broadcast  every single transaction between the two of them  back to the Bitcoin block chain.  In a way doing so is actually kind of wasteful.

If I’m just transacting and changing a balance of one  Bitcoin back and forth between two people,  why does the block chain need to know  about that necessarily?  And this really helps to answer the question also  that I get a lot where people say,  “Well if we have the Lightning Network  “and it scales to 40,000 transactions per second”  or some crazy amount like that, why do we need Bitcoin?”  And the answer is because the Lightning Network  is Bitcoin.  It’s just Bitcoin where you’re not putting everything  on the block chain.  You’re still cryptographically signing  the transactions, but sharing them privately  with the individuals that are taking part  in the transaction.  And so that concept covers two people that are  transacting with on another.

The use case of it might be if I have a friend  that I know I’m gonna be transacting regularly with,  we’ll open up a payment channel for a sizeable  enough amount, and then we can send money  back and forth to one another with no  transaction fees and it never has to  hit the Bitcoin network.  The next obvious question is, well how does  this facilitate transactions between a large  group of people?  So if I wanna send money to somebody on the other  side of the world who I don’t currently  have an open payment channel with, can I?  And the answer is yes, probably.  Think of this as kind of that six degrees  of separation thing.

I might not have a channel open with that person  on the other side of the world, but there’s a chance  that my friend, who I do have an open payment  channel with does.  Or maybe a friend of a friend of a friend  has a payment channel open with the person  I’m trying to send money to.  And so as long as there’s a route from me  to the other person, through these payment channels  that I have previously set up,  then money can make its way across that route.  An example to illustrate this would be  that Alice wants to send money back and forth  with Bob, but unfortunately Alice and Bob  don’t have an existing payment channel set up,  and they don’t wanna create a new payment channel  because that would involve paying a transaction  fee on the Bitcoin network and getting everything  set up with the commitments.

So Alice and Bob don’t have a connection to one another,  but they do have a connection with  somebody called David.  Alice already has a payment channel with David,  and so does Bob.  And so as long as those existing payment channels  will facilitate the amount of money  that Alice and Bob wanna send back to one another,  then they can actually send that money through David.  Now the challenge here is how do you do this  in a trustless way, where you can trust David  to be kind of this intermediary between the two of you.  And you have to think, this is a very simple example,  in the future it might not just be David you’re  going through as an intermediary,  there might be 20 hops that you have to take  before you’re actually getting to the person  that you finally wanna transact with.

So there’s a lot of people there that you have  to trust to do the right thing.  And so the way that the Lightning Network  does this is through something called Hashed TimeLock  Contracts, and so the simplest way to explain this  is that Alice and Bob both give David  basically a countdown, a time in which he has  to cryptographically prove that a payment  was made or received before that deadline,  otherwise the money just gets refunded  to the last person so it gets back  to the previous owners or the person trying to send it.  And so really in a nutshell, that’s all  the payment channel is.  That’s all the Lightning Network is.  It’s a bunch of people with these two way contracts  that they sign every time they want to change the state of.

And it’s a network of these people,  transacting with one another to find  routes to pay each other.  And you can see how this has a bunch of benefits,  because the only time you’re actually putting  a transaction on to the Bitcoin block chain  and paying the transaction fees is when you open  or close a channel, if you keep a channel open  for a long period of time, then you can basically  send unlimited transactions back and forth  with somebody with very minimal to zero  transaction cost.  And because you’re just cryptographically signing  this two of two transaction every time you wanna  change the state of the payment channel,  payments are settled instantly.You don’t have to wait 10 minutes for the next  Bitcoin block to be mined and written into history.


So if this network works, and people start using  it and there’s enough viability in these  linked wallets and these routes between people,  then this could be a very viable solution  to scaling Bitcoin.  In a way that we’re not actually writing transactions  to the Bitcoin block chain anymore, it’s a bunch  of private wallets interacting with one another,  and only touching the Bitcoin block chain  when you wanna pull the money out of that channel.  And there’s current implementations of this  that people can go and start using once SegWit locks in.

On Litecoin actually, which already has SegWit activated,  there’s a running test then I believe for  the Lightning Network.  So this stuff is definitely on the horizon  and I’ve seen some wallets and other pieces  of technology around this start to pop up.  So over the next six to 12 months,  I think this technology is definitely gonna be  relatively mainstream, but that’s not to say  that the Lightning Network or payment channels  are perfect.  There’s definitely some drawbacks and challenges  that this technology faces.

The first big issue is that offline payments  aren’t really supported.  Because every time you wanna change  the state of a payment channel,  the two parties have to sign that transaction,  that multisig transaction we talked about,  those wallets or those clients essentially  have to be talking to one another in realtime.  So if a person that you have a payment channel  with goes offline and you can’t contact them  and they can’t sign to change the state,  then your money is kind of stuck in there  at the current state of the channel.

The other potential issue is that because the channel  can be closed by sending previous transactions  back to the Bitcoin network, that means  that these clients actually have to be monitoring  the Bitcoin block chain at all times  to make sure that their private transactions  aren’t actually being transmitted and broadcast  back to the Bitcoin network.  Basically in order to make sure you can keep trusting  this person you have a channel open with,  you need to constantly be monitoring  the status of the Bitcoin block chain  and making sure there’s no funny business going on.  And the other big challenge is that it’s not actually  very good for large transactions.

If you’re relying on these routes  that hop multiple people that have existing  payment channels open, the amount that you can send  to the person at the other end is entirely  limited by how large those payment channels are.  And so in that Alice, Bob, and then David linking  the two situation that I discussed,  if Alice and Bob only have payment channels  open for say 0.2 of a Bitcoin with David,  then that’s the maximum they can actually send  to one another through that route.

You can’t magically send one Bitcoin across  a payment channel that’s only currently worth 0.2 Bitcoin.  And so in that case, Alice and Bob would actually  have to open up a new payment channel  in order to send money to one another,  and if they’re opening another payment channel,  which has to happen on the chain anyway,  then why wouldn’t they just send the Bitcoin  to one another using the traditional on-chain method?  Because of this large payment routing issue,  the Lightning Network’s specification  actually limits payments to 0.04 something of a Bitcoin,  which is relatively small really.  So for that reason, it’s going to be very interesting  to see the real use cases of the Lightning Network.

I guess it could kinda work if people are doing  micro transactions between one another,  or maybe you have a payment channel open with  your local coffee shop, and you transact that way.  But getting back to that always online problem,  obviously things like Lite Wallets on mobile,  or even the desktop really, or web services,  aren’t going to have the ability to be  constantly monitoring the block chain,  and keeping a realtime connection open  with all of their peers.  And so a lot of people are predicting  that what’s gonna happen is these centralized hubs  are gonna open up and they’ll offer essentially  a Lightning Node as a service, which essentially  acts as a hub, and your way to interact with other  people on the Lightning Network.

Now in earlier iterations of the Lightning Network,  there was talk about this hub and spoke  kind of model where you had essentially these  large credit unions, which would run a service,  and people would interact with it.  And then that hub was basically your David  in the previous example I gave.  They are the ones that are connecting with  multiple hundreds of thousands of people  with these open payment channels,  and you’re simply using that hub to then send  to another person that’s connected to that same hub.

The problem with this, and I think the reason  the Lightning team moved away from that hub  and spoke model, is there is some form  of centralization there.  If you think about it, if you wanna open a channel  that’s bidirectional, i.e. you’re sending money  back and forth, the person opening that hub  has to have a lot of capital in order to start  those payment channels.  Say for every user, you wanted to open a  payment channel that’s worth $500 bidirectionally  so you can send money back and forth,  if you have 1,000 users using that hub,  that hub actually has to commit $50,000 worth of Bitcoin  in order to keep these payment channels open.

So basically the ability to run one of these hubs,  or these kind of Lightning Nodes as a service  becomes exclusionary for the smaller players.  And I think what we’ll see is existing services  that have a lot of money, things like exchanges  or mining pools, start setting up these hubs  and operating.  The only problem there is again, it’s kind of a form  of centralization sadly.  It does mean that it’s gonna scale way better,  but if it’s centralized, then is that a trade off  that the Bitcoin network and its users are willing to make.

My kind of personal opinion on this  is that there are potential use cases for payment  channels, I think we just haven’t fully realized them yet.  And I’m not sure if necessarily those use cases  are going to be aligned with the way  that people are using Bitcoin today.  But it might be for other things, like micro transactions,  recurring transactions that you have with somebody  on a regular basis and it makes sense to have a payment  channel open for a long period of time,  because the whole kind of benefit of the Lightning Network  goes away if you’re constantly opening  and closing channels all the time  and essentially creating transactions on-chain  every time you do that.

If you’re still writing transactions to the block chain  and having to pay the transaction fees,  then the benefit of the Lightning Network  kinda goes away.  You have to have these payment channels open  for a long period of time to kind of reap  the benefit of that network.  So that’s kind of my simplified breakdown  of what a payment channel is, what Lightning does.  There’s obviously a lot more to it technically,  and I’ll try and link to some resources  where you can go and read more about it.

But with Segregated Witness hopefully activating  in the next month, I think we’re gonna be  hearing a lot more about this technology  and start to see wallets supporting it,  potentially exchanges supporting it in the future  as an alternative to sending on-chain transactions.  I hope you found this video useful  and it explained payment channels in kind of an  easy to understand way.  As always, if you like the video, please like  and subscribe.  I’m trying to produce these videos on a weekly basis,  and always open to topic suggestions in the comments below.  Again, thanks for watching, I hope you found this  useful and I’ll see you next time.

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What are payment channels? (eg. the Lightning Network)