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", "benefits of Bitcoin system")))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
as 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)

((("blockchain applications", "building blocks for
(primitives)")))((("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 any time.

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.

Nonexpiration:: 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:: Multisignature constraints in scripts impose a
quorum of authorization, predefined in the multisignature 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 is not complete and more are added with each
new feature introduced into bitcoin.

=== Applications from Building Blocks

((("blockchain applications", "examples of")))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):: ((("digital notary
services")))((("Proof of Existence")))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:: ((("payment (state) channels", "building blocks
(primitives) used in")))Quorum of Control + Timelock + No Double Spend +
Nonexpiration + Censorship Resistance + Authorization. A multisig 2-of-2
(Quorum) with a timelock (Timelock) used as the "settlement" transaction
of a payment channel can be held (Nonexpiration) and spent at any time
(Censorship Resistance) by either party (Authorization). The two parties
can then create commitment transactions that double-spend (No
Double-Spend) the settlement on a shorter timelock (Timelock).

=== Colored Coins

((("blockchain applications", "colored coins",
id="BCAcoins12")))((("colored coins", id="color12")))The first
blockchain application we will discuss is _colored coins_.

((("extrinsic asset management")))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.

((("digital asset management")))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.

((("Enhanced Padded-Order-Based Coloring (EPOBC)")))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.

More recent implementations of colored coins use the +OP_RETURN+ script
opcode to store metadata in a transaction, in conjunction with external
data stores that associate the metadata to specific assets.

((("Open Assets")))The two most prominent implementations of colored
coins today are http://www.openassets.org/[_Open Assets_] and
http://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, transferred, 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&#x2013;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 https://www.coinprism.info[coinprism].

A Colu Colored Coins-compatible wallet application and blockchain
explorer can be found at http://coloredcoins.org/explorer/[Blockchain
Explorer].

A Copay wallet plug-in can be found at
http://coloredcoins.org/colored-coins-copay-addon/[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 (e.g., 5) or have decimal subdivision (e.g.,
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 (e.g.,
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 multisig 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 coins protocol.

<<the_issuance_transaction_as_viewed_on_coinprismio>> shows 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_coinprismio]]
.The issuance transaction as viewed on coinprism.info
image::images/mbc2_1201.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!
====

((("transaction IDs (txid)")))The transaction ID of the issuance
transaction is a "normal" bitcoin transaction ID.
<<the_issuance_transaction_on_a_block>> shows 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]]
.The issuance transaction on a block explorer that doesn't decode colored coins
image::images/mbc2_1202.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 &amp; coinbase" on that screen, you can see
more detail about the transaction
(<<the_scripts_in_the_issuance_transaction>>).

[[the_scripts_in_the_issuance_transaction]]
.The scripts in the issuance transaction
image::images/mbc2_1203.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 that 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:

[role="pagebreak-before"]
[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
----

((("", startref="color12")))((("", startref="BCAcoins12")))If we
retrieve this URL, we get a JSON-encoded asset definition, as shown
here:

[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

((("blockchain applications",
"Counterparty")))((("Counterparty")))((("smart contracts")))((("Ethereum
Virtual Machine (EVM)")))((("extrinsic asset management")))((("virtual
asset management")))Counterparty is a protocol layer built on top of
bitcoin. The Counterparty protocol, similar 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.

((("digital ownership")))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[].

[[state_channels]]
=== Payment Channels and State Channels

_Payment channels_ ((("blockchain applications", "payment (state)
channels", id="BCApayment12")))((("payment (state) channels",
"defined")))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 (submillisecond) 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.

((("payment (state) channels", "concept of")))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
(unidirectional) payment channel for a metered micropayment service,
such as streaming video. Then, we will expand on this mechanism and
introduce bidirectional payment channels. Finally, we will look at how
bidirectional channels can be connected end-to-end to form multihop
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&#x2014;Basic Concepts and Terminology

((("payment (state) channels", "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.

<<payment_channel>> illustrates a payment channel between Bob and Alice,
showing the funding, commitment, and settlement transactions.((("use
cases", "buying coffee", startref="alicetwelve")))

[[payment_channel]]
.A payment channel between Bob and Alice, showing the funding, commitment, and settlement transactions
image::images/mbc2_1204.png["A payment channel between Bob and Alice, showing the funding, commitment, and settlement transactions"]

==== Simple Payment Channel Example

((("payment (state) channels", "example of", id="PSCexample12")))To
explain state channels, we 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 micropayment 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. <<emma_fabian_streaming_video>> shows Emma buying the video
streaming service from Fabian using a payment channel.

[[emma_fabian_streaming_video]]
.Emma purchases streaming video from Fabian with a payment channel, paying for each second of video
image::images/mbc2_1205.png["Emma purchases streaming video from Fabian with a payment channel, paying for each second of video"]

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 set up 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&#x2014;it requires two
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 0.02 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 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.

<<video_payment_channel>> shows the channel between Emma and Fabian and
the commitment transactions that update the balance of the channel.

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.((("", startref="PSCexample12")))

[[video_payment_channel]]
.Emma's payment channel with Fabian, showing the commitment transactions that update the balance of the channel
image::images/mbc2_1206.png["Emma's payment channel with Fabian, showing the commitment transactions that update the balance of the channel"]

==== Making Trustless Channels

((("payment (state) channels", "making trustless channels",
id="PSCtrust12")))The channel we just described 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 these problems can be solved with timelocks&#x2014;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 only the refund
transaction 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. If not, the most recent commitment transaction
can be propagated to settle the account and invalidate all prior
commitment transactions.

For example, if commitment transaction #1 is timelocked to 4320 blocks
in the future, then commitment transaction #2 is timelocked to 4319
blocks in the future. Commitment transaction #600 can be spent 600
blocks before commitment transaction #1 becomes valid.

<<timelocked_commitments>> shows each commitment transaction setting a
shorter timelock, allowing it to be spent before the previous
commitments become valid.

[[timelocked_commitments]]
.Each commitment sets a shorter timelock, allowing it to be spent before the previous commitments become valid
image::images/mbc2_1207.png["Each commitment sets a shorter timelock, allowing it to be spent before the previous commitments become valid"]

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 enforce smart contracts across a time
dimension. In this example we saw how the time dimension guarantees that
the most recent commitment transaction becomes valid before any earlier
commitments. Thus, the most recent commitment transaction can be
transmitted, spending the inputs and invalidating prior commitment
transactions. The enforcement of smart contracts with absolute timelocks
protects against cheating by one of the parties. 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 pass:[<a href="https://streamium.io/" class="orm:hideurl"><em>streamium.io</em></a>].

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 any time.

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
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 that 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.((("", startref="PSCtrust12")))

==== Asymmetric Revocable Commitments

((("payment (state) channels", "asymmetric revocable commitments",
id="PSCaymetric12")))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 owed 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.

<<asymmetric_commitments>> shows two asymmetric commitment transactions,
where the output paying the holder of the commitment is delayed.

[[asymmetric_commitments]]
.Two asymmetric commitment transactions with delayed payment for the party holding the transaction
image::images/mbc2_1208.png["Two asymmetric commitment transactions with delayed payment for the party holding the transaction"]

Now we introduce the final element of this scheme: a revocation key that
prevents a cheater from broadcasting an expired commitment. The
revocation key allows the wronged party to punish the cheater by taking
the entire balance of the channel.

The revocation key is composed of two secrets, each half generated
independently by each channel participant. It is similar to a 2-of-2
multisig, but constructed using elliptic curve arithmetic, so that both
parties know the revocation public key but each party knows only half
the revocation secret key.

In each round, both parties reveal their half of the revocation secret
to the other party, thereby giving the other party (who now has both
halves) the means to claim the penalty output if this revoked
transaction is ever broadcast.

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, penalizing transmission of a revoked commitment.

So when Hitesh creates a commitment transaction for Irene to sign, he
makes the second output payable to himself after 1000 blocks, or to the
revocation public key (of which he only knows half the secret). Hitesh
constructs this transaction. He will only reveal his half of the
revocation secret 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 his half of
the _revocation key_ to Irene. Once Irene has both halves of the
revocation secret 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_. Meanwhile, Hitesh only has half the revocation secret for that
revocation public key and can't redeem the output until 1000 blocks.
Irene will be able to redeem the output and punish Hitesh before the
1000 blocks have elapsed.

The revocation protocol is bilateral, meaning that in each round, as the
channel state is advanced, the two parties exchange new commitments,
exchange revocation secrets for the previous commitments, and sign each
other's new commitment transactions. As they accept a new state, they
make the prior state impossible to use, by giving each other the
necessary revocation secrets 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!((("", startref="PSCaymetric12")))

==== Hash Time Lock Contracts (HTLC)

((("Hash Time Lock Contracts (HTLC)")))((("payment (state) channels",
"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 bidirectional 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 _preimage_ to the hash function. The
preimage is just the data that is used as input to a hash function.

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
    <Payer Public 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 payer 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+.((("", startref="BCApayment12")))

[[lightning_network]]
=== Routed Payment Channels (Lightning Network)

((("blockchain applications", "routed payment channels",
seealso="Lightning Network", id="BCAlightning12")))((("routed payment
channels", see="Lightning Network")))((("Lightning Network",
"defined")))The Lightning Network is a proposed routed network of
bidirectional 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
https://lightning.network/lightning-network-paper.pdf[first described by
Joseph Poon and Thadeus Dryja in February 2015], building on the concept
of payment channels as proposed and elaborated upon by many others.

"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. ((("Basics of Lightning Technology
(BOLT)")))The independent implementations are coordinated by a set of
interoperability standards described in the
http://bit.ly/2rBHeoL[_Basics of Lightning Technology (BOLT)_ paper].

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 segwit, 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

((("Lightning Network", "basic example")))Let's see how this works.

In this example, we have five participants: Alice, Bob, Carol, Diana,
and Eric. These five 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.

<<lightning_network_fig>> shows five participants in a Lightning
Network, connected by bidirectional payment channels that can be linked
to make a payment from Alice to Eric (<<lightning_network>>).

[[lightning_network_fig]]
.A series of bidirectional payment channels linked to form a Lightning Network that can route a payment from Alice to Eric
image::images/mbc2_1209.png["A series of bi-directional payment channels linked to form a Lightning Network"]

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?

<<ln_payment_process>> shows the step-by-step process of routing a
payment from Alice to Eric, through a series of HTLC commitments on the
payment channels connecting the participants.

[[ln_payment_process]]
.Step-by-step payment routing through a Lightning Network
image::images/mbc2_1210.png["Step-by-step payment routing through a Lightning Network"]

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 (see
<<ln_payment_process>> step 1).

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 (see <<ln_payment_process>> step 2). 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
three 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+ (see <<ln_payment_process>>
step 3). Bob knows that if Carol can claim his HTLC, she has to produce
+R+. If Bob has +R+ in nine blocks, he can use it to claim Alice's HTLC
to him. He also makes 0.001 bitcoin for committing his channel balance
for nine 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 nine
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 eight blocks, which Diana can redeem if she has
secret +R+ (see <<ln_payment_process>> step 4). 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 if +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 seven
blocks to hash +H+ (see <<ln_payment_process>> step 5). 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 (see
<<ln_payment_process>> step 6). 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 (see <<ln_payment_process>> step 7). 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 (see
<<ln_payment_process>> step 8). Finally, Bob claims the HTLC from Alice
(see <<ln_payment_process>> step 9). 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 and Routing

((("Lightning Network", "transport and routing")))All communications
between LN nodes are encrypted point-to-point. In addition, nodes have a
long-term public key that they http://bit.ly/2r5TACm[use as an
identifier and to authenticate each other].

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://bit.ly/2r5TACm[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 http://bit.ly/2q6ZDrP[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 backward.
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 multilayer "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.((("",
startref="alicetwelve")))

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

((("Lightning Network", "benefits of")))A Lightning Network is a
second-layer routing technology. It can be applied to any blockchain
that supports some basic capabilities, such as multisignature
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:: Lightning Network 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:: A Lightning Network makes it much more difficult to apply
surveillance and blacklists on bitcoin, increasing the fungibility of
the currency.

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

Granularity:: A Lightning Network can enable payments at least as small
as the bitcoin "dust" limit, perhaps even smaller. Some proposals allow
for subsatoshi increments.

Capacity:: A Lightning Network 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 a Lightning
Network, as it depends only on the capacity and speed of each node.

Trustless Operation:: A Lightning Network uses bitcoin transactions
between nodes that operate as peers without trusting each other. Thus, a
Lightning Network 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 toward 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.((("", startref="BCAlightning12")))

=== 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.