bitcoinbook/ch12.asciidoc

[[ch12]]
== Blockchain Applications

Let's now build on our understanding of bitcoin by looking at it as an _application platform_. Nowadays, many people use the term "blockchain" to refer to any application platform that shares the design principles of bitcoin. The term is often misused and applied to many things that fail to deliver the primary features that bitcoin's blockchain delivers.

In this chapter we will look at the features offered by the bitcoin blockchain, as an application platform. We will consider the application building _primitives_, which form the building blocks of any blockchain application. We will look at several important applications that use these primitives, such as: colored coins, payment (state) channels and routed payment channels (Lightning Network).

=== Introduction

((("blockchain applications", id="ix_ch12-asciidoc0", range="startofrange")))The bitcoin system was designed as a decentralized currency and payment system. However, most of its functionality is derived from much lower level constructs that can be used for much broader applications. Bitcoin wasn't built with components such as accounts, users, balances and payments. Instead, it uses a transactional scripting language with low level cryptographic functions, as we saw in <<transactions>>. Just like the higher-level concepts of accounts, balances and payments can be derived from these basic primitives, so can many other complex applications. Thus, the bitcoin blockchain can become an application platform offering trust services to applications, such as smart contracts, far surpassing the original purpose of digital currency and payments.

=== Building Blocks (Primitives)

When operating correctly and over the long term, the bitcoin system offers certain guarantees, which can be used as building blocks to create applications. These include:

No Double-Spend:: The most fundamental guarantee of bitcoin's decentralized consensus algorithm ensures that no UTXO can be spent twice.

Immutability:: Once a transaction is recorded in the blockchain and sufficient work has been added with subsequent blocks, the transaction's data becomes immutable. Immutability is underwritten by energy, as rewriting the blockchain requires the expenditure of energy to produce proof of work. The energy required and therefore the degree of immutability increases with the amount of work committed on top of the block containing a transaction.

Neutrality:: The decentralized bitcoin network propagates valid transactions regardless of the origin or content of those transactions. This means that anyone can create a valid transaction with sufficient fees and trust they will be able to transmit that transaction and have it included in the blockchain at anytime.

Secure Timestamping:: The consensus rules reject any block whose timestamp is too far in the past or future. This ensures that timestamps on blocks can be trusted. The timestamp on a block implies an unspent-before guarantee for the inputs of all included transactions.

Authorization:: Digital signatures, validated in a decentralized network, offer authorization guarantees. Scripts that contain a requirement for a digital signature cannot be executed without authorization by the holder of the private key implied in the script.

Auditability:: All transactions are public and can be audited. All transactions and blocks can be linked back in an unbroken chain to the genesis block.

Accounting:: In any transaction (except the coinbase transaction) the value of inputs is equal to the value of outputs plus fees. It is not possible to create or destroy bitcoin value in a transaction. The outputs cannot exceed the inputs.

Non-Expiration:: A valid transaction does not expire. If it is valid today, it will be valid in the near future, as long as the inputs remain unspent and the consensus rules do not change.

Integrity:: A bitcoin transaction signed with SIGHASH_ALL or parts of a transaction signed by another SIGHASH type cannot be modified without invalidating the signature, thus invalidating the transaction itself.

Transaction Atomicity:: Bitcoin transactions are atomic. They are either valid and confirmed (mined) or not. Partial transactions cannot be mined and there is no interim state for a transaction. At any point in time a transaction is either mined, or not.

Discrete (Indivisible) Units of Value:: Transaction outputs are discrete and indivisible units of value. They can either be spent or unspent, in full. They cannot be divided or partially spent.

Quorum of Control:: Multi-signature constraints in scripts impose a quorum of authorization, predefined in the multi-signature scheme. The M-of-N requirement is enforced by the consensus rules.

Timelock/Aging:: Any script clause containing a relative or absolute timelock can only be executed after its age exceeds the time specified.

Replication:: The decentralized storage of the blockchain ensures that when a transaction is mined, after sufficient confirmations, it is replicated across the network and becomes durable and resilient to power loss, data loss etc.

Forgery Protection:: A transaction can only spend existing, validated outputs. It is not possible to create or counterfeit value.

Consistency:: In the absence of miner partitions, blocks that are recorded in the blockchain are subject to reorganization or disagreement with exponentially decreasing likelihood, based on the depth at which they are recorded. Once deeply recorded, the computation and energy required to change makes change practically infeasible.

Recording External State:: A transaction can commit a data value, via OP_RETURN, representing a state transition in an external state machine.

Predictable Issuance:: Less than 21 million bitcoin will be issued, at a predictable rate.

The list of building blocks above is not complete and more are added with each new feature introduced into bitcoin.

=== Applications from Building Blocks

The building blocks offered by bitcoin are elements of a trust platform that can be used to compose applications. Here are some examples of applications that exist today and the building blocks they use:

Proof-of-Existence (Digital Notary):: Immutability + Timestamp + Durability. A digital fingerprint can be committed with a transaction to the blockchain, proving that a document existed (Timestamp) at the time it was recorded. The fingerprint cannot be modified ex-post-facto (Immutability) and the proof will be stored permanently (Durability).

Kickstarter (Lighthouse):: Consistency + Atomicity + Integrity. If you sign one input and the output (Integrity) of a fundraiser transaction, others can contribute to the fundraiser but it cannot be spent (Atomicity) until the goal (output value) is funded (Consistency).

Payment Channels:: Quorum of Control + Timelock + No Double Spend + Non-Expiration + Censorship Resistance + Authorization. A multi-sig 2-of-2 (Quorum) with a timelock (Timelock), used as the "settlement" transaction of a payment channel can be held (Non-Expiration) and spent whenever (Censorship Resistance) by either party (Authorization). The two parties can then create update transactions that double-spend (No Double Spend) the settlement on a shorter timelock (Timelock).

=== Colored Coins

The first blockchain application we will discuss is _Colored Coins_

Colored coins refers to a set of similar technologies that use bitcoin transactions to record the creation, ownership and transfer of extrinsic assets other than bitcoin. By "extrinsic" we mean assets that are not stored directly on the bitcoin blockchain, as opposed to bitcoin itself which is an asset intrinsic to the blockchain.

Colored coins are used to track digital assets as well as physical assets held by third parties and traded through colored coins certificates of ownership. Digital asset colored coins can represent intangible assets such as a stock certificate, license, virtual property (game items), or most any form of licensed intellectual property (trademarks, copyrights, etc). Tangible asset colored coins can represent certificates of ownership of commodities (gold, silver, oil), land title, automobiles, boats, aircraft, etc.

The term derives from the idea of "coloring" or marking a nominal amount of bitcoin, for example a single satoshi, to represent something other than the bitcoin value itself. As an analogy, consider stamping a $1 note with a message saying "This is a stock certificate of ACME" or "This note can be redeemed for 1 oz of silver" and then trading the $1 note as a certificate of ownership of this other asset. The first implementation of colored coins, named _Enhanced Padded-Order-Based Coloring_ or _EPOBC_ assigned extrinsic assets to a 1 satoshi output. In this way, it was a true "colored coin", as each asset was added as an attribute (color) of a single satoshi.

After _EPOBC_, more recent implementations of colored coins use the OP_RETURN script opcode to store metadata in a transaction, in conjunction with external data stores which associate the metadata to specific assets.

The two most prominent implementations of colored coins today are http://www.openassets.org/[_Open Assets_] and https://coloredcoins.org[_Colored Coins by Colu_]. These two systems use different approaches to colored coins and are not compatible. Colored coins created in one system cannot be seen or used in the other system.

==== Using Colored Coins

Colored coins are created, transfered and generally viewed in special wallets that can interpret the colored coins protocol metadata attached to bitcoin transactions. Special care must be taken to avoid using a colored coin related key in a regular bitcoin wallet, as the regular wallet may destroy the metadata. Similarly, colored coins should not be sent to addresses managed by regular wallets, but only to addresses that are managed by wallets that are colored-coin-aware. Both Colu and Open Assets systems use special colored-coin addresses to mitigate this risk and to ensure that colored coins are not sent to unaware wallets.

Colored coins are also not visible to most general-purpose blockchain explorers. Instead, you must use a colored-coins explorer to interpret the metadata of a colored coins transaction.

An Open Assets compatible wallet application and blockchain explorer can be found at:

coinprism: https://www.coinprism.info[https://www.coinprism.info]

A Colu Colored Coins compatible wallet application and blockchain explorer can be found at:

Blockchain Explorer: http://coloredcoins.org/explorer/[http://coloredcoins.org/explorer/]

Copay wallet plugin:
http://coloredcoins.org/colored-coins-copay-addon/[http://coloredcoins.org/colored-coins-copay-addon/]

==== Issuing Colored Coins

Each of the colored coins implementations has a different way of creating colored coins, but they all provide similar functionality. The process of creating a colored coin asset is called _issuance_. An initial transaction, the _issuance transaction_ registers the asset on the bitcoin blockchain and creates an _asset ID_ that is used to reference the asset. Once issued, assets can be transferred between addresses using _transfer transactions_.

Assets issued as colored coins can have multiple properties. They can be _divisible_ or _indivisible_, meaning that the amount of asset in a transfer can be an integer (eg. 5) or have decimal subdivision (eg. 4.321). Assets can also have _fixed issuance_, meaning a certain amount are issued only once, or can be _reissued_, meaning that new units of the asset can be issued by the original issuer after the initial issuance.

Finally, some colored coins enable _dividends_, allowing the distribution of bitcoin payments to the owners of a colored coin asset in proportion to their ownership.

==== Colored Coins Transactions

The metadata that gives meaning to a colored coin transaction is usually stored in one of the outputs using the OP_RETURN opcode. Different colored coins protocols use different encodings for the content of the OP_RETURN data. The output containing the OP_RETURN is called the _marker output_.

The order of the outputs and position of the marker output may have special meaning in the colored coins protocol. In Open Assets, for example, any outputs before the marker output represent asset issuance. Any outputs after the marker represent asset transfer. The marker output assigns specific values and colors to the other outputs by referencing their order in the transaction.

In Colored Coins (Colu), by comparison, the marker output encodes an opcode that determines how the metadata is interpreted. Opcodes 0x01 through 0x0F indicate an issuance transaction. An issuance opcode is usually followed by an asset ID or other identifier that can be used to retrieve the asset information from an external source (eg. bittorrent).
Opcodes 0x10 through 0x1F represent a transfer transaction.  Transfer transaction metadata contain simple scripts that transfer specific amounts of assets from inputs to outputs, by reference to their index. Ordering of inputs and outputs is therefore important in the interpretation of the script.

If the metadata is too long to fit in OP_RETURN, the colored coins protocol may use other "tricks" to store metadata in a transaction. Examples include putting metadata in a redeem script, followed by OP_DROP opcodes to ensure the script ignores the metadata. Another mechanism used is a 1-of-N multi-sig script where only the first public key is a real public key that can spend the output and subsequent "keys" are replaced by encoded metadata.

In order to correctly interpret the metadata in a colored coins transaction you must use a compatible wallet or block explorer. Otherwise, the transaction looks like a "normal" bitcoin transaction with an OP_RETURN output.

As an example, I created and issued a MasterBTC asset using colored coins. The MasterBTC asset represents a voucher for a free copy of this book. These vouchers can be transferred, traded and redeemed using a colored coins compatible wallet.

For this particular example, I used the wallet and explorer at http://coinprism.info/[https://coinprism.info], which uses the Open Assets colored coin protocol.

Let's look at the issuance transaction using the Coinprism block explorer:

https://www.coinprism.info/tx/10d7c4e022f35288779be6713471151ede967caaa39eecd35296aa36d9c109ec[https://www.coinprism.info/tx/10d7c4e022f35288779be6713471151ede967caaa39eecd35296aa36d9c109ec]

.The Issuance Transaction - as viewed on coinprism.info
image::images/coinprism_issuance.png[The Issuance Transaction - as viewed on coinprism.info]

As you can see, coinprism shows the issuance of 20 units of "Free copy of Mastering Bitcoin", the MasterBTC asset, to a special colored coin address +akTnsDt5uzpioRST76VFRQM8q8sBFnQiwcx+

[WARNING]
====
Any funds or colored assets sent to this address will be lost forever. Do not send value to this example address!
====

The transaction ID of the issuance transaction is a "normal" bitcoin transaction ID. Let's look at that same transaction in a block explorer that doesn't decode colored coins. We'll use blockchain.info

https://blockchain.info/tx/10d7c4e022f35288779be6713471151ede967caaa39eecd35296aa36d9c109ec[https://blockchain.info/tx/10d7c4e022f35288779be6713471151ede967caaa39eecd35296aa36d9c109ec]

.The Issuance Transaction - on a block explorer that doesn't decode colored coins
image::images/coloredcoins_tx.png[The Issuance Transaction - on a block explorer that doesn't decode colored coins]

As you can see, blockchain.info doesn't recognize this as a colored coins transaction. In fact, it marks the second output with "Unable to decode output address" in red letters.

If you select "Show scripts & coinbase" on that screen, you can see more detail about the transaction:

.The scripts in the Issuance Transaction
image::images/coloredcoins_tx_scripts.png[The scripts in the Issuance Transaction]

Once again, blockchain.info doesn't understand the second output. It marks it with "Strange" in red letters. However, we can see some of the metadata in the marker output is human-readable:

----
OP_RETURN 4f41010001141b753d68747470733a2f2f6370722e736d2f466f796b777248365559
(decoded) "OA____

u=https://cpr.sm/FoykwrH6UY
----

Let's retrieve the transaction using +bitcoin-cli+:

----
$ bitcoin-cli decoderawtransaction `bitcoin-cli getrawtransaction 10d7c4e022f35288779be6713471151ede967caaa39eecd35296aa36d9c109ec`
----

Stripping out the rest of the transaction, the second output looks like this:

[source,json]
----
{
  "value": 0.00000000,
  "n": 1,
  "scriptPubKey": "OP_RETURN 4f41010001141b753d68747470733a2f2f6370722e736d2f466f796b777248365559"

}
----

The prefix +4F41+ represents the letters "OA" which stands for "Open Assets" and helps us identify that what follows is metadata defined by the Open Assets protocol. The ASCII encoded string that follows is a link to an asset definition:

----
u=https://cpr.sm/FoykwrH6UY
----

If we retrieve this URL, we get a JSON encoded asset definition, as shown below:

[source,json]
----
{
  "asset_ids": [
    "AcuRVsoa81hoLHmVTNXrRD8KpTqUXeqwgH"
  ],
  "contract_url": null,
  "name_short": "MasterBTC",
  "name": "Free copy of \"Mastering Bitcoin\"",
  "issuer": "Andreas M. Antonopoulos",
  "description": "This token is redeemable for a free copy of the book \"Mastering Bitcoin\"",
  "description_mime": "text/x-markdown; charset=UTF-8",
  "type": "Other",
  "divisibility": 0,
  "link_to_website": false,
  "icon_url": null,
  "image_url": null,
  "version": "1.0"
}
----

=== Counterparty

Counterparty is a protocol layer built on top of bitcoin. The Counterparty protocol, similarly to colored coins, offers the ability to create and trade virtual assets and tokens. In addition, Counterparty offers a decentralized exchange for assets. Counterparty is also implementing smart contracts, based on the Ethereum Virtual Machine (EVM).

Like the colored coins protocols, Counterparty embeds metadata in bitcoin transactions, using the OP_RETURN opcode or 1-of-N multisignature addresses that encode metadata in the place of public keys. Using these mechanisms, Counterparty implements a protocol layer encoded in bitcoin transactions. The additional protocol layer can be interpreted by applications that are Counterparty-aware, such as wallets and blockchain explorers, or any application built using the Counterparty libraries.

Counterparty can be used as a platform for other applications and services, in turn. For example, Tokenly, is a platform built on top of Counterparty that allows content creators, artists and companies to issue tokens that express digital ownership and can be used to rent, access, trade or shop for content, products and services. Other applications leveraging Counterparty include games (Spells of Genesis) and grid computing projects (Folding Coin).

More details about Counterparty can be found at https://counterparty.io. The open source project can be found at https://github.com/CounterpartyXCP


=== Payment Channels and State Channels

_Payment Channels_ are a trustless mechanism for exchanging bitcoin transactions between two parties, outside of the bitcoin blockchain. These transactions, which would be valid if settled on the bitcoin blockchain, are held off-chain instead, acting as _promissory notes_ for eventual batch settlement. Because the transactions are not settled, they can be exchanged without the usual settlement latency, allowing extremely high transaction throughput, low (sub-millisecond) latency and fine (satoshi-level) granularity.

Actually, the term channel is a metaphor. State channels are virtual constructs represented by the exchange of state between two parties, outside of the blockchain. There are no "channels", per-se and the underlying data transport mechanism is not the channel. We use the term channel to represent the relationship and shared state between two parties, outside of the blockchain.

To further explain this concept, think of a TCP stream. From the perspective of higher-level protocols it is a "socket" connecting two applications across the Internet. But if you look at the network traffic, a TCP stream is just a virtual channel over IP packets. Each endpoint of the TCP stream sequences and assembles IP packets to create the illusion of a stream of bytes. Underneath, it's all disconnected packets. Similarly, a payment channel is just a series of transactions. If properly sequenced and connected, they create redeemable obligations that you can trust even though you don't trust the other side of the channel.

In this section we will look at various forms of payment channels. First we will examine the mechanisms used to construct a one-way (uni-directional) payment channel for a metered micro-payment service, such as streaming video. Then, we will expand on this mechanism and introduce bi-directional payment channels. Finally, we will look at how bi-directional channels can be connected end-to-end to form multi-hop channels in a routed network, first proposed under the name _Lightning Network_.

Payment channels are part of the broader concept of a _State Channel_, which represents an off-chain alteration of state, secured by eventual settlement in a blockchain. A payment channel is a state channel where the state being altered is the balance of a virtual currency.

==== State Channels - Basic Concepts and Terminology

A state channel is established between two parties, through a transaction that locks a shared state on the blockchain. This is called the _funding transaction_ or _anchor transaction_. This single transaction must be transmitted to the network and mined to establish the channel. In the example of a payment channel, the locked state is the initial balance (in currency) of the channel.

The two parties then exchange signed transactions, called _commitment transactions_ that alter the initial state. These transactions are valid transactions in that they _could_ be submitted for settlement by either party, but instead are held off-chain by each party pending the channel closure. State updates can be created as fast as each party can create, sign and transmit a transaction to the other party. In practice this means that thousands of transactions per second can be exchanged.

When exchanging commitment transactions the two parties also invalidate the previous states, so that the most up-to-date commitment transaction is always the only one that can be redeemed. This prevents either party from cheating by unilaterally closing the channel with an expired prior state that is more favorable to them than the current state. We will examine the various mechanisms that can be used to invalidate prior state in the rest of this chapter.

Finally, the channel can be closed either cooperatively, by submitting a final _settlement transaction_ to the blockchain, or unilaterally by either party submitting the last commitment transaction to the blockchain. A unilateral close option is needed in case one of the parties unexpectedly disconnects. The settlement transaction represents the final state of the channel and is settled on the blockchain.

In the entire lifetime of the channel, only two transactions need to be submitted for mining on the blockchain: the funding and settlement transactions. In between these two states, the two parties can exchange any number of commitment transactions that are never seen by anyone else, nor submitted to the blockchain.

==== Simple Payment Channel Example

To explain state channels, we have to start with a very simple example. We demonstrate a one-way channel, meaning that value is flowing in one direction only. We will also start with the naive assumption that no one is trying to cheat, to keep things simple. Once we have the basic channel idea explained, we will then look at what it takes to make it trustless so that neither party *can* cheat, even if they are trying to.

For this example we will assume two participants: Emma and Fabian. Fabian offers a video streaming service that is billed by the second, using a micro-payment channel. Fabian charges 0.01 millibit (0.00001 BTC) per second of video, equivalent to 36 millibits (0.036 BTC) per hour of video. Emma is a user who purchases this streaming video service from Fabian.

In this example, Fabian and Emma are using special software that handles both the payment channel and the video streaming. Emma is running the software in her browser, Fabian is running it on a server. The software includes basic bitcoin wallet functionality and can create and sign bitcoin transactions. Both the concept and the term "payment channel" are completely hidden from the users. What they see is video that is paid for by the second.

To setup the payment channel, Emma and Fabian establish a 2-of-2 multisignature address, with each of them holding one of the keys. From Emma's perspective, the software in her browser presents a QR code with a P2SH address (starting with "3"), and asks her to submit a "deposit" for up to 1 hour of video. The address is then funded by Emma. Emma's transaction, paying to the multisignature address is the funding or anchor transaction for the payment channel.

For this example, let's say that Emma funds the channel with 36 millibits (0.036 BTC). This will allow Emma to consume *up to* 1 hour of streaming video. The funding transaction in this case sets the maximum amount that can be transmitted in this channel, setting the _channel capacity_.

The funding transaction consumes one or more inputs from Emma's wallet, sourcing the funds. It creates one output with a value of 36 millibits paid to the multisignature 2-of-2 address controlled jointly between Emma and Fabian. It may have additional outputs for change back to Emma's wallet.

Once the funding transaction is confirmed, Emma can start streaming video. Emma's software creates and signs a commitment transaction that changes the channel balance to credit 0.01 millibit to Fabian's address and refund 35.99 millibits back to Emma. The transaction signed by Emma consumes the 36 millibits output created by the funding transaction and creates two outputs: one for her refund, the other for Fabian's payment. The transaction is only partially signed - it requires 2 signatures (2-of-2), but only has Emma's signature. When Fabian's server receives this transaction, it adds the second signature (for the 2-of-2 input) and returns it to Emma together with 1 second worth of video. Now both parties have a fully signed commitment transaction that either can redeem, representing the correct up-to-date balance of the channel. Neither party broadcasts this transaction to the network.

In the next round, Emma's software creates and signs another commitment transaction (commitment #2) that consumes the *same* 2-of-2 output from the funding transaction. The second commitment transaction allocates one output of 0.2 millibits to Fabian's address and one output of 35.98 millibits back to Emma's address. This new transaction is payment for two cumulative seconds of video. Fabian's software signs and returns the second commitment transaction, together with the another second of video.

In this way, Emma's software continues to send commitment transactions to Fabian's server in exchange for streaming video. The balance of the channel gradually accumulates in favor of Fabian, as Emma consumes more seconds of video. Let's say Emma watches 600 seconds (10 minutes) of video, creating and signing 600 commitment transactions. The last commitment transaction (#600) will have two outputs, splitting the balance of the channel 6 millibits to Fabian and 30 millibits to Emma.

Finally, Emma clicks "Stop" to stop streaming video. Either Fabian or Emma can now transmit the final state transaction for settlement. This last transaction is the _settlement transaction_ and pays Fabian for all the video Emma consumed, refunding the remainder of the funding transaction to Emma.

In the end, only two transactions are recorded on the blockchain: the funding transaction that established the channel and a settlement transaction that allocated the final balance correctly between the two participants.

==== Making Trustless Channels

The channel we described above works, but only if both parties cooperate, without any failures or attempts to cheat. Let's look at some of the scenarios that break this channel and see what is needed to fix those:

* Once the funding transaction happens, Emma needs Fabian's signature to get any money back. If Fabian disappears, Emma's funds are locked in a 2-of-2 and effectively lost. This channel, as constructed, leads to a loss of funds if one of the parties disconnects before there is at least one commitment transaction signed by both parties.

* While the channel is running, Emma can take any of the commitment transactions Fabian has countersigned and transmit one to the blockchain. Why pay for 600 seconds of video, if she can transmit commitment transaction #1 and only pay for 1 second of video? The channel fails because Emma can cheat by broadcasting a prior commitment that is in her favor.

Both of the above problems can be solved with timelocks, let's look at how we could use transaction level timelocks (nLockTime).

Emma cannot risk funding a 2-of-2 multisig unless she has a guaranteed refund. To solve this problem, Emma constructs the funding and refund transaction at the same time. She signs the funding transaction but doesn't transmit it to anyone. Emma transmits the refund transaction, only, to Fabian and obtains his signature.

The refund transaction acts as the first commitment transaction and its timelock establishes the upper bound for the channel's life. In this case, Emma could set the nLockTime to 30 days or 4320 blocks into the future. All subsequent commitment transactions must have a shorter timelock, so that they can be redeemed before the refund transaction.

Now that Emma has a fully signed refund transaction, she can confidently transmit the signed funding transaction knowing that she can eventually, after the timelock expires, redeem the refund transaction even if Fabian disappears.

Every commitment transaction the parties exchange during the life of the channel will be timelocked into the future. But the delay will be slightly shorter for each commitment so the most recent commitment can be redeemed before the prior commitment it invalidates. Because of the nLockTime, neither party can successfully propagate any of the commitment transactions until their timelock expires. If all goes well, they will cooperate and close the channel gracefully with a settlement transaction, making it unnecessary to transmit an intermediate commitment transaction. In essence, the commitment transactions are only used in

For example, commitment transaction 1 cannot be spent before 1000 blocks, then if commitment transaction 2 is timelocked to 995 blocks. Commitment transaction 600 can be spent 600 blocks earlier than commitment transaction 1.

Each subsequent commitment transaction must have a shorter timelock so that it may be broadcast before its predecessors and before the refund transaction. The ability to broadcast a commitment earlier ensures it will be able to spend the funding output and preclude any other commitment transaction from being redeemed by spending the output. The guarantees offered by the bitcoin blockchain, preventing double spends and enforcing timelocks, effectively allow each commitment transaction to invalidate its predecessors.

State channels use timelocks to establish smart contracts across a time dimension. In this example we saw how the time dimension guarantees that a fair commitment, representing the correct channel balance can be transmitted and confirmed before an unfair commitment transaction, representing a channel's prior state, can be transmitted and confirmed. This implementation, needs nothing more than absolute transaction level timelocks (nLockTime). Next we will see how script level timelocks, CHECKLOCKTIMEVERIFY and CHECKSEQUENCEVERIFY can be used to construct more flexible, useful, and sophisticated state channels.

The first form of unidirectional payment channel was demonstrated as a prototype video streaming application in 2015 by an Argentinian team of developers. You can still see it at streamium.io.

Timelocks are not the only way to invalidate prior commitment transactions. In the next sections we will see how a revocation key can be used to achieve the same result. Timelocks are effective but they have two distinct disadvantages. By establishing a maximum timelock when the channel is first opened, they limit the lifetime of the channel. Worse they force channel implementations to strike a balance between allowing long lived channels and forcing one of the participants to wait a very long time for a refund in case of premature closure. For example, if you allow the channel to remain open for 30 days, by setting the refund timelock to 30 days, if one of the parties disappears immediately the other party must wait 30 days for a refund. The more distant the endpoint, the more distant the refund.

The second problem is that since each subsequent commitment transaction must decrement the timelock, there is an explicit limit on the number of commitment transactions that can be exchanged between the parties. For example, a 30 day channel, setting a timelock of 4320 blocks into the future, can only accommodate 4320 intermediate commitment transactions before it must be closed. There is a danger in setting the timelock commitment transaction interval at 1 block. By setting the timelock interval between commitment transactions to 1 block, a developer is creating a very high burden for the channel participants who have to be vigilant, remain online and watching, and be ready to transmit the right commitment transaction at anytime.

Now that we understand how timelocks can be used to invalidate prior commitments, we can see the difference between closing the channel cooperatively and closing it unilaterally by broadcasting a commitment transaction. All commitment transactions are timelocked, therefore broadcasting a commitment transaction will always involve waiting until the timelock has expired. But if the two parties agree on what the final balance is and know they both hold commitment transactions that will make eventually make that balance a reality, they can construct a settlement transaction without a timelock representing that same balance. In a cooperative close, either party takes the most recent commitment transaction, and builds a settlement transaction that is identical in every way except it omits the timelock. Both parties can sign this settlement transaction knowing there is no way to cheat and get a more favorable balance. By cooperatively signing and transmitting the settlement transaction they can close the channel and redeem their balance immediately. Worst case, one of the parties can be petty, refuse to cooperate and force the other party to do a unilateral close with the most recent commitment transaction. But if they do that, they have to wait for their funds too.

==== Asymmetric Revocable Commitments

A better way to handle the prior commitment states is to explicitly revoke them. However, this is not easy to achieve. A key characteristic of bitcoin is that once a transaction is valid, it remains valid and does not expire. The only way to cancel a transaction is by double-spending its inputs with another transaction before it is mined. That's why we used timelocks in the simple payment channel example above, to ensure that more recent commitments could be spent before older commitments were valid. However, sequencing commitments in time creates a number of constraints that make payment channels difficult to use.

Even though a transaction cannot be canceled, it can be constructed in such a way as to make it undesirable to use. The way we do that is by giving each party a _revocation key_ that can be used to punish the other party if they try to cheat. This mechanism for revoking prior commitment transactions was first proposed as part of the Lightning Network.

To explain revocation keys, we will construct a more complex payment channel between two exchanges run by Hitesh and Irene. Hitesh and Irene run bitcoin exchanges in India and the USA, respectively. Customers of Hitesh's Indian exchange often send payments to customers of Irene's USA exchange and vice versa. Currently, these transactions occur on the bitcoin blockchain, but this means paying fees and waiting several blocks for confirmations. Setting up a payment channel between the exchanges will significantly reduce the cost and accelerate the transaction flow.

Hitesh and Irene start the channel by collaboratively constructing a funding transaction, each funding the channel with 5 bitcoin.
The initial balance is 5 bitcoin for Hitesh and 5 bitcoin for Irene. The funding transaction locks the channel state in a 2-of-2 multisig, just like in the example of a simple channel.

The funding transaction may have one or more inputs from Hitesh (adding up to 5 bitcoin or more), and one or more inputs from Irene (adding up to 5 bitcoin or more). The inputs have to slightly exceed the channel capacity in order to cover the transaction fees. The transaction has one output that locks the 10 total bitcoin to a 2-of-2 multisig address controlled by both Hitesh and Irene. The funding transaction may also have one or more outputs returning change to Hitesh and Irene if their inputs exceeded their intended channel contribution. This is a single transaction with inputs offered and signed by two parties. It has to be constructed in collaboration and signed by each party before it is transmitted.

Now, instead of creating a single commitment transaction that both parties sign, Hitesh and Irene create two different commitment transactions that are *asymmetric*:

Hitesh has a commitment transaction with two outputs. The first output pays Irene the 5 bitcoin she is owed *immediately*. The second output pays Hitesh the 5 bitcoin he is owed, but only after a timelock of 1000 blocks. The transaction outputs look like this:

----
Input: 2-of-2 funding output, signed by Irene

Output 0 <5 bitcoin>:
    <Irene's Public Key> CHECKSIG

Output 1:
    <1000 blocks>
    CHECKSEQUENCEVERIFY
    DROP
    <Hitesh's Public Key> CHECKSIG
----

Irene has a different commitment transaction with two outputs. The first output pays Hitesh the 5 bitcoin he is owed immediately. The second output pays Irene the 5 bitcoin she is own but only after a timelock of 1000 blocks. The commitment transaction Irene holds (signed by Hitesh), looks like this:

----
Input: 2-of-2 funding output, signed by Hitesh

Output 0 <5 bitcoin>:
    <Hitesh's Public Key> CHECKSIG

Output 1:
    <1000 blocks>
    CHECKSEQUENCEVERIFY
    DROP
    <Irene's Public Key> CHECKSIG
----

This way, each party has a commitment transaction, spending the 2-of-2 funding output. This input is signed by the *other* party. At any time the party holding the transaction can also sign (completing the 2-of-2) and broadcast. However, if they broadcast the commitment transaction, it pays the other party immediately whereas they have to wait for a short timelock to expire. By imposing a delay on the redemption of one of the outputs, we put each party at a slight disadvantage when they choose to unilaterally broadcast a commitment transaction. But a time delay, alone, isn't enough to encourage fair conduct.

Now we introduce the final element of this scheme: a revocation key that allows a wronged party to punish a cheater by taking the entire balance of the channel.

Each of the commitment transactions has a "delayed" output. The redemption script for that output allows one party to redeem it after 1000 blocks *or* the other party to redeem it if they have a revocation key. So when Hitesh creates a commitment transaction for Irene to sign, he makes the second output payable to himself after 1000 blocks, or to whoever can present a revocation key. Hitesh constructs this transaction and creates a revocation key that he keeps secret. He will only reveal it to Irene when he is ready to move to a new channel state and wants to revoke this commitment. The second output's script looks like this:

----
Output 0 <5 bitcoin>:
    <Irene's Public Key> CHECKSIG

Output 1 <5 bitcoin>:
IF
    # Revocation penalty output
    <Revocation Public Key>
ELSE
    <1000 blocks>
    CHECKSEQUENCEVERIFY
    DROP
    <Hitesh's Public Key>
ENDIF
CHECKSIG
----

Irene can confidently sign this transaction, since if transmitted it will immediately pay her what she is owed. Hitesh holds the transaction, but knows that if he transmits it in a unilateral channel closing, he will have to wait 1000 blocks to get paid.

When the channel is advanced to the next state, Hitesh has to _revoke_ this commitment transaction, before Irene agrees to sign the next commitment transaction. To do that, all he has to do is send the _revocation key_ to Irene. Once Irene has the revocation key for this commitment, she can sign the next commitment with confidence. She knows that if Hitesh tries to cheat by publishing the prior commitment, she can use the revocation key to redeem Hitesh's delayed output. *If Hitesh cheats, Irene gets BOTH outputs*.

The revocation protocol is bilateral, meaning that in each round, as the channel state is advanced, the two parties exchange new commitments, exchange revocation keys for the previous commitment and sign each other's commitment transactions. As they accept a new state, they make the prior state impossible to use, by giving each other the necessary revocation keys to punish any cheating.

Let's look at an example of how it works. One of Irene's customers wants to send 2 bitcoin to one of Hitesh's customers. To transmit 2 bitcoin across the channel, Hitesh and Irene must advance the channel state to reflect the new balance. They will commit to a new state (state number 2) where the channel's 10 bitcoin are split 7 bitcoin to Hitesh and 3 bitcoin to Irene. To advance the state of the channel, they will each create new commitment transactions reflecting the new channel balance.

As before, these commitment transactions are asymmetric so that the commitment transaction each party holds forces them to wait if they redeem it. Crucially, before signing new commitment transactions, they must first exchange revocation keys to invalidate the prior commitment. In this particular case, Hitesh's interests are aligned with the real state of the channel and therefore he has no reason to broadcast a prior state. However, for Irene, state number 1 leaves her with a higher balance than state 2. When Irene gives Hitesh the revocation key for her prior commitment transaction (state number 1) she is effectively revoking her ability to profit from regressing the channel to a prior state because with the revocation key, Hitesh can redeem both outputs of the prior commitment transaction without delay. Meaning if Irene broadcasts the prior state, Hitesh can exercise his right to take all of the outputs.

Importantly, the revocation doesn't happen automatically. While Hitesh has the ability to punish Irene for cheating, he has to watch the blockchain diligently for signs of cheating. If he sees a prior commitment transaction broadcast, he has 1000 blocks to take action and use the revocation key to thwart Irene's cheating and punish her by taking the entire balance, all 10 bitcoin.

Asymmetric revocable commitments with relative time locks (CSV) are a much better way to implement payment channels and a very significant innovation in this technology.  With this construct, the channel can remain open indefinitely and can have billions of intermediate commitment transactions. In prototype implementations of Lightning Network, the commitment state is identified by a 48-bit index, allowing more than 281 trillion (2.8 x 10^14^) state transitions in any single channel!

==== Hash Time Lock Contracts (HTLC)

Payment channels can be further extended with a special type of smart contract that allows the participants to commit funds to a redeemable secret, with an expiration time. This feature is called a _Hash Time Lock Contract_ or _HTLC_ and is used in both bi-directional and routed payment channels.

Let's first explain the "hash" part of the HTLC. To create an HTLC, the intended recipient of the payment will first create a secret +R+. They then calculate the hash of this secret +H+:

----
H = Hash(R)
----

This produces a hash +H+ that can be included in an output's locking script. Whoever knows the secret can use it to redeem the output. The secret +R+ is also referred to as a _pre-image_ to the hash function. Pre-image just means the data that is used as input to a hash function.

[TIP]
====
The hash function used....

====

The second part of an HTLC is the "time lock" component. If the secret is not revealed, the payer of the HTLC can get a "refund" after some time. This is achieved with an absolute time lock using CHECKLOCKTIMEVERIFY.

The script implementing an HTLC might look like this:

----
IF
    # Payment if you have the secret R
    HASH160 <H> EQUALVERIFY
ELSE
    # Refund after timeout.
    <locktime> CHECKLOCKTIMEVERIFY DROP
    <Payee Pubic Key> CHECKSIG
ENDIF
----

Anyone who knows the secret +R+, which when hashed equals to +H+, can redeem this output by exercising the first clause of the +IF+ flow.

If the secret is not revealed and the HTLC claimed, after a certain number of blocks the payee can claim a refund using the second clause in the +IF+ flow.

This is a basic implementation of an HTLC. This type of HTLC can be redeemed by *anyone* who has the secret R. An HTLC can take many different forms with slight variations to the script. For example, adding a CHECKSIG operator and a public key in the first clause restricts redemption of the hash to a named recipient, who must also know the secret R.

=== Routed Payment Channels (Lightning Network)

The Lightning Network is a proposed routed network of bi-directional payment channels connected end-to-end. A network like this can allow any participant to route a payment from channel to channel without trusting any of the intermediaries. The Lightning Network was first described by Joseph Poon and Thadeus Dryja in February 2015, building on the concept of payment channels as proposed and elaborate by many others:

http://lightning.network/lightning-network-paper.pdf[lightning.network/lightning-network-paper.pdf]

"Lightning Network" refers to a specific design for a routed payment channel network, which has now been implemented by at least five different open source teams. The independent implementations are coordinated by a set of interoperability standards described in the _Basics of Lightning Technology (BOLT)_ papers:

https://github.com/lightningnetwork/lightning-rfc/blob/master/00-introduction.md[https://github.com/lightningnetwork/lightning-rfc/blob/master/00-introduction.md]

Prototype implementations of the Lightning Network have been released by several teams. For now, these implementations can only be run on testnet because they use Segregated Witness, which is not activated on the main bitcoin blockchain (mainnet).

The Lightning Network is one possible way of implementing routed payment channels. There are several other designs that aim to achieve similar goals, such as Teechan and Tumblebit.

==== Basic Lightning Network Example

Let's see how this works.

In this example, we have 5 participants: Alice, Bob, Carol, Diana, and Eric. These 5 participants have opened payment channels with each other, in pairs. Alice has a payment channel with Bob. Bob is connected to Carol, Carol to Diana and Diana to Eric. For simplicity let's assume each channel is funded with 2 bitcoin by each participant, for a total capacity of 4 bitcoin in each channel.

Alice wants to pay Eric 1 bitcoin. However, Alice is not connected to Eric by a payment channel. Creating a payment channel requires a funding transaction, which must be committed to the bitcoin blockchain. Alice does not want to open a new payment channel and commit more of her funds. Is there a way to pay Eric, indirectly?

Alice is running a Lightning Network (LN) node that is keeping track of her payment channel to Bob and has the ability to discover routes between payment channels. Alice's LN node also has the ability to connect over the Internet to Eric's LN node. Eric's LN node creates a secret R using a random number generator. Eric's node does not reveal this secret to anyone. Instead, Eric's node calculates a hash +H+ of the secret +R+ and transmits this hash to Alice's node.

Now Alice's LN node constructs a route between Alice's LN node and Eric's LN node. The routing algorithm used will be examined in more detail later, but for now let's assume that Alice's node can find an efficient route.

Alice's node then constructs an HTLC, payable to the hash +H+, with a 10 block refund timeout (current block + 10), for an amount of 1.003 bitcoin. The extra 0.003 will be used to compensate the intermediate nodes for their participation in this payment route. Alice offers this HTLC to Bob, deducting 1.003 bitcoin from her channel balance with Bob and committing it to the HTLC. The HTLC has the following meaning: _"Alice is committing 1.003 of her channel balance to be paid to Bob if Bob knows the secret, or refunded back to Alice's balance if 10 blocks elapse."_. The channel balance between Alice and Bob is now expressed by commitment transactions with 3 outputs: 2 bitcoin balance to Bob, 0.997 bitcoin balance to Alice, 1.003 bitcoin committed in Alice's HTLC. Alice's balance is reduced by the amount committed to the HTLC.

Bob now has a commitment that if he is able to get the secret +R+ within the next 10 blocks, he can claim the 1.003 locked by Alice. With this commitment in hand, Bob's node constructs an HTLC on his payment channel with Carol. Bob's HTLC commits 1.002 bitcoin to hash +H+ for 9 blocks, which Carol can redeem if she has secret +R+. Bob knows that if Carol can claim his HTLC, she has to produce +R+. If Bob has +R+ in 9 blocks, he can use it to claim Alice's HTLC to him. He also makes 0.001 bitcoin for committing his channel balance for 9 blocks. If Carol is unable to claim his HTLC and he is unable to claim Alice's HTLC, everything reverts back to the prior channel balances and no one is at a loss. The channel balance between Bob and Carol is now: 2 to Carol, 0.998 to Bob, 1.002 committed by Bob to the HTLC.

Carol now has a commitment that if she gets +R+ within the next 9 blocks, she can claim 1.002 bitcoin locked by Bob. Now she can make an HTLC commitment on her channel with Diana. She commits an HTLC of 1.001 bitcoin to hash +H+, for 8 blocks, which Diana can redeem if she has secret +R+. From Carol's perspective, if this works she is 0.001 bitcoin better off and if it doesn't she loses nothing. Her HTLC to Diana is only viable +R+ is revealed, at which point she can claim the HTLC from Bob. The channel balance between Carol and Diana is now: 2 to Diana, 0.999 to Carol, 1.001 committed by Carol to the HTLC.

Finally, Diana can offer an HTLC to Eric, committing 1 bitcoin for 7 blocks to hash +H+. The channel balance between Diana and Eric is now: 2 to Eric, 1 to Diana, 1 committed by Diana to the HTLC.

However, at this hop in the route, Eric *has* secret +R+. He can therefore claim the HTLC offered by Diana. He sends +R+ to Diana and claims the 1 bitcoin, adding it to his channel balance. The channel balance is now: 1 to Diana, 3 to Eric.

Now, Diana has secret +R+. Therefore, she can now claim the HTLC from Carol. Diana transmits +R+ to Carol and adds the 1.001 bitcoin to her channel balance. Now the channel balance between Carol and Diana is: 0.999 to Carol, 3.001 to Diana. Diana has "earned" 0.001 for participating in this payment route.

Flowing back through the route, the secret +R+ allows each participant to claim the outstanding HTLCs. Carol claims 1.002 from Bob, setting the balance on their channel to: 0.998 to Bob, 3.002 to Carol. Finally, Bob claims the HTLC from Alice. Their channel balance is updated as: 0.997 to Alice, 3.003 to Bob.

Alice has paid Eric 1 bitcoin without opening a channel to Eric. None of the intermediate parties in the payment route had to trust each other. For the short-term commitment of their funds in the channel they are able to earn a small fee, with the only risk being a small delay in refund if the channel was closed or the routed payment failed.

==== Lightning Network Transport & Routing

All communications between Lightning Network nodes are encrypted point-to-point. In addition, nodes have a long-term public key that they use as an identifier and to authenticate each other.http://bitfury.com/content/5-white-papers-research/whitepaper_flare_an_approach_to_routing_in_lightning_network_7_7_2016.pdf

Whenever a node wishes to send a payment to another node, it must first construct a _path_ through the network by connecting payment channels with sufficient capacity. Nodes advertise routing information, including what channels they have open, how much capacity each channel has and what fees they charge to route payments. The routing information can be shared in a variety of ways and different routing protocols are likely to emerge as Lightning Network technology advances. Some Lightning Network implementations use the IRC protocol as a convenient mechanism for nodes to announce routing information. Another implementation of route discovery uses a P2P model where nodes propagate channel announcements to their peers, in a "flooding" model, similar to how bitcoin propagates transactions. Future plans include a proposal called http://bitfury.com/content/5-white-papers-research/whitepaper_flare_an_approach_to_routing_in_lightning_network_7_7_2016.pdf[Flare], which is a hybrid routing model with local node "neighborhoods" and longer-range beacon nodes.

In our previous example, Alice's node uses one of these route discovery mechanisms to find one or more paths connecting her node to Eric's node. Once Alice's node has constructed a path, she will initialize that path through the network, by propagating a series of encrypted and nested instructions to connect each of the adjacent payment channels.

Importantly, this path is only known to Alice's node. All other participants in the payment route see only the adjacent nodes. From Carol's perspective, this looks like a payment from Bob to Diana. Carol does not know that Bob is actually relaying a payment from Alice. She also doesn't know that Diana will be relaying a payment to Eric.

This is a critical feature of the Lightning Network, because it ensures privacy of payments and makes it very difficult to apply surveillance, censorship or blacklists. But how does Alice establish this payment path, without revealing anything to the intermediary nodes?

The Lightning Network implements an _Onion Routed Protocol_ based on a scheme called https://cypherpunks.ca/~iang/pubs/Sphinx_Oakland09.pdf[Sphinx]. This routing protocol ensures that a payment sender can construct and communicate a path through the Lightning Network such that:

* Intermediate nodes can verify and decrypt their portion of route information and find the next hop

* Other than the previous and next hops, they cannot learn about any other nodes that are part of the path

* They cannot identify the length of the payment path, or their own position in that path

* Each part of the path is encrypted in such a way that a network-level attacker cannot associate the packets from different parts of the path to each other

* Unlike Tor, (an onion routed anonymization protocol on the Internet), there are no "exit nodes" that can be placed under surveillance. The payments do not need to be transmitted to the bitcoin blockchain, the nodes just update channel balances.

Using this onion routed protocol, Alice wraps each element of the path in a layer of encryption, starting with the end and working backwards. She encrypts a message to Eric with Eric's public key. This message is wrapped in a message encrypted to Diana, identifying Eric as the next recipient. The message to Diana is wrapped in a message encrypted to Carol's public key and identifying Diana as the next recipient. The message to Carol is encrypted to Bob's key. Thus, Alice has constructed this encrypted multi-layer "onion" of messages. She sends this to Bob, who can only decrypt and unwrap the outer layer. Inside, Bob finds a message addressed to Carol that he can forward to Carol but cannot decipher himself. Following the path, the messages get forwarded, decrypted, forwarded etc, all the way to Eric. Each participant knows only the previous and next node in each hop.

Each element of the path contains information on the HTLC that must be extended to the next hop, the amount that is being sent, the fee to include and the CLTV locktime (in blocks) expiration of the HTLC. As the route information propagates, the nodes make HTLC commitments forward to the next hop.

At this point, you might be wondering how it is possible that the nodes do not know the length of the path and their position in that path. After all, they receive a message and forward it to the next hop. Doesn't it get shorter, allowing them to deduce the path size and their position? To prevent this, the path is always fixed at 20 hops and padded with random data. Each node sees the next hop and a fixed length encrypted message to forward. Only the final recipient sees that there is no next hop. To everyone else it seems as if there are always 20 more hops to go.

==== Lightning Network Benefits

A Lightning Network is a second-layer routing technology. It can be applied to any blockchain that supports some basic capabilities, such as multi-signature transactions, timelocks and basic smart contracts.

If a Lightning Network is layered on top of the bitcoin network, the bitcoin network can gain a significant increase in capacity, privacy, granularity and speed, without sacrificing the principles of trustless operation without intermediaries.

Privacy:: LN payments are much more private than payments on the bitcoin blockchain, as they are not public. While participants in a route can see payments propagated across their channels, they do not know the sender or recipient.

Fungibility:: LN makes it much more difficult to apply surveillance and blacklists on bitcoin, increasing the fungibility of the currency.

Speed:: Bitcoin transactions using LN are settled in milliseconds, rather than minutes, as HTLCs are cleared without committing transactions to a block.

Granularity:: LN can enable payments at least as small as the bitcoin "dust" limit, perhaps even smaller. Some proposals allow for sub-satoshi increments.

Capacity:: LN increases the capacity of the bitcoin system by several orders of magnitude. There is no practical upper bound to the number of payments per second that can be routed over LN, as it depends only on the capacity and speed of each node.

Trustless Operation:: LN uses bitcoin transactions between nodes that operate as peers without trusting each other. Thus, LN preserves the principles of the bitcoin system, while expanding its operating parameters significantly.

Of course, as mentioned previously, the Lightning Network protocol is not the only way to implement routed payment channels. Other proposed systems include Tumblebit and Teechan. At this time, however, the Lightning Network has already been deployed on testnet. Several different teams have developed competing implementations of LN and are working towards a common interoperability standard (called BOLT). It is likely that Lightning Network will be the first routed payment channel network to be deployed in production.

=== Conclusion

We have examined just a few of the emerging applications that can be built using the bitcoin blockchain as a trust platform. These applications expand the scope of bitcoin beyond payments and beyond financial instruments, to encompass many other applications where trust is critical. By decentralizing the basis of trust, the bitcoin blockchain is a platform that will spawn many revolutionary applications in a wide variety of industries.